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V^fsa^/a-r- 



94th Congress 
2d Session 



COMMITTEE PRINT 



TAX EXPENDITURES 

Compendium of Background Material 
on Individual Provisions 



COMMITTEE ON THE BUDGET 
UNITED STATES SENATE 




MARCH 17, 1976 




Printed for the use of the Committee on the Budget 



67-312 



U.S. GOVERNMENT PRINTING OFFICE 

WASHINGTON : 1976 



For sale b the Superintendent of Documents, U.S. Government Printing Office 
Washington, D.C., 20402 - Price $2.20 



COMMITTEE ON THE BUDGET 



EDMUND S. MUSKIE, Maine, Chairman 



HENRY BELLMON, Oklahoma 
ROBERT DOLE, Kansas 
J. GLENN BEALL, Jr., Maryland 
JAMES l! BUCKLEY, New York 
JAMES A. McCLURE, Idaho 
PETE V. DOMENICI, New Mexico 



WARREN G. MAGNUSON, Washington 
FRANK E. MOSS, Utah 
WALTER F. MONDALE, Minnesota 
ERNEST F. HOLLINGS, South Carolina 
ALAN CRANSTON, California 
LAWTON CHILES, Florida 
JAMES ABOUREZK, South Dakota 
JOSEPH R. BIDEN, Jr., Delaware 
SAM NUNN, Georgia 

Douglas J. Bennet, Jr., Staff Director 

John T. McEvoy, Chief Counsel 

Robert S. Boyd, Minority Staff Director 

W. Thomas Foxwell, Director of Publications 

(n) 



LETTER OF TRANSMITTAL 



To the Members of the Committee on the Budget: 

The Congressional Budget and Impoundment Control Act of 1974 
requires that the Budget Committees and the Congress examine tax 
expenditures as part of overall Federal budgetary policy. This re- 
quirement stems from a recognition that numerous provisions of 
Federal tax law confer benefits on some individuals and institutions 
that are comparable to direct Federal spending, but that these tax 
law benefits seldom are reviewed, in comparison with direct spending 
programs. 

This Committee print has been prepared to gather together basic 
background information concerning tax expenditures to assist members 
of the Budget Committee and other Members of the Congress in 
carrying out their responsibilities with respect to tax expenditures 
under the Budget Act. It is a compendium of summaries which 
describes the operation and impact of each tax expenditure; indicates 
the authorization and rationale for its enactment and perpetuation; 
estimates both the revenue loss attributable to each provision and, 
where provisions affect individual taxpayers directly, the percentage 
distribution by adjusted gross income class of the tax savings conferred 
by the provision; and cites selected bibliography for each provision. 

The concept of tax expenditures is a relatively new one which is 
still in the process of being refined, both with respect to the provisions 
classified as tax expenditures and the methods of calculating the rev- 
enue losses stemming from such provisions. Nevertheless, failure to 
take tax expenditures into account in the budget process now would 
be to overlook significant segments of Federal policy. They should be 
given particularly thorough scrutiny because, as the compendium 
indicates, tax expenditures are generally enacted as permanent legis- 
lation and thus are comparable to continuing direct spending entitle- 
ment programs, often with increasing annual revenue losses. 

This compendium was prepared jointly by Jane Gravelle of the 
Congressional Research Service, Ronald Hoffman, Charles Davenport, 
John Roth, and Roger Golden of the Congressional Budget Office, and 
Ira Tannenbaum, Kenneth Biederman, and Bert Carp of the Budget 
Committee staff. 

Nothing in this compendium should be interpreted as representing 
the views or recommendations of the Budget Committee or any of its 
individual members. 
Sincerely, 

Henry Bellmon, Edmund S. Muskie, 

Ranking Minority Member. Chairman. 

Walter F. Mondale, 

Chairman, Task Force on Tax 
Policy, and Tax Expenditures. 
(in) 



Digitized by the Internet Archive 
in 2013 



http://archive.org/details/taxexpOOunit 



CONTENTS 



Page 

Letter of transmittal m 

Introduction 1 

National defense: 

Exclusion of benefits and allowances to Armed Forces 7 

Exclusion of military disability pensions 9 

International affairs: 

Exclusion of gross-up on dividends of less developed country corpora- 
tions 11 

Exclusion of certain income earned abroad by U.S. citizens 13 

Deferral of income of Domestic International Sales Corporations 

(DISCs) 15 

Special rates for Western Hemisphere Trade Corporations 19 

Deferral of income of controlled foreign corporations 21 

Agriculture: 

Expensing of certain capital outlays 23 

Capital gain treatment of certain income 25 

Natural Resources, Environment, and Energy: 

Expensing of intangible drilling, exploration and development costs__ 27 

Excess of percentage over cost depletion 31 

Capital gain treatment of royalties on coal and iron ore 35 

Timber : Capital gains treatment of certain income 37 

Pollution control : 5-year amortization 39 

Commerce and Transportation: 

Corporate surtax exemption 41 

Deferral of tax on shipping companies 43 

Railroad rolling stock: 5-year amortization 45 

Bad debt deductions of financial institutions in excess of actual losses. _ 47 

Deductibility of nonbusiness State gasoline taxes 49 

Depreciation on rental housing in excess of straight line, and deprecia- 
tion on buildings (other than rental housing) in excess of straight 

line 51 

Expensing of research and development costs 55 

Investment tax credit 57 

Asset depreciation range 61 

Dividend exclusion 63 

Capital gains : Individual (other than farming and timber) 65 

Capital gains treatment: Corporate (other than farming and timber). 67 

Exclusion of capital gains at death 71 

Deferral of capital gains on home sales 73 

Deductibility of mortgage interest and property taxes on owner- 
occupied property 75 

Exemption of credit unions 77 

Deductibility of interest on consumer credit 79 

Credit for purchasing new home 81 

(V) 



VI 

Community and Regional Development: Page 

Housing rehabilitation : 5-year amortization 83 

Education, Training, Employment, and Social Services: 

5-year amortization of child care facilities 85 

Exclusion of scholarships and fellowships 87 

Parental personal exemption for student age 19 or over 89 

Deductibility of charitable contributions to educational institutions 

other than educational institutions 91 

Deductibility of child and dependent care services 95 

Credit for employing public assistance recipients under Work In- 
centive (WIN) Program 97 

Health: 

Exclusion of employer contributions to medical insurance premiums 

and medical care 99 

Deductibility of medical expenses 101 

Income Security: 

Exclusion of social security benefits (disability insurance benefits, 
OASI benefits for the aged, and benefits for dependents and sur- 
vivors) 103 

Exclusion of railroad retirement benefits 105 

Exclusion of sick pay 107 

Exclusion of unemployment insurance benefits 109 

Exclusion of worker's compensation benefits 111 

Exclusion of public assistance benefits 113 

Net exclusion of pension contributions and earnings : 

Employer plans 115 

Plans for self-employed and others 117 

Exclusion of other employee benefits: 

Premiums on group term life insurance 119 

Premiums on accident and accidental death insurance 121 

Privately financed supplementary unemployment benefits 123 

Meals and lodging 125 

Exclusion of interest on life insurance savings 127 

Exclusion of capital gains on house sales if over 65 129 

Deductibility of casualty losses 131 

Excess of percentage standard deduction over low income allowance. 133 

Additional exemption for the blind 135 

Additional exemption for over 65 137 

Retirement income credit 139 

Earned income credit 143 

Maximum tax on earned income 145 

Veterans' Benefits and Services: 

Exclusion of disability compensation, pensions, and GI bill benefits. _ 147 
General Government: 

Credits and deductions for political contributions 149 

Revenue Sharing and General Purpose Fiscal Assistance: 

Exclusion of interest on State and local bond debt 151 

Exclusion of income earned in U.S. possessions 155 

Deductibility of nonbusiness State and local taxes (other than on 

owner-occupied homes and gasoline) 157 

Appendix A: 

Forms of tax expenditures 159 

Appendix B: 

Capital gains 105 



INTRODUCTION 



This compendium gathers basic information concerning 74 Federal 
income tax provisions currently treated as tax expenditures. The 
provisions included in this compendium are the same as those listed 
in Estimates of Federal Tax Expenditures, prepared for the Committee 
on Ways and Means and the Committee on Finance by the staffs of 
the Treasury Department and Joint Committee on Internal Revenue 
Taxation (July 8, 1975). With respect to each of these expenditures, 
this compendium provides: 

An estimate of the Federal revenue loss associated with the 
provision for individual and corporate taxpavers, for fiscal vears 
1975, 1976, and 1977; 

The legal authorization for the provision (e.g., Internal Revenue 
Code section, Treasury Department regulation, or Treasury 
ruling); 

A description of the tax expenditure, including an example of 
its operation where this is useful; 

A brief analysis of the impact of the provision; 

An estimate, where applicable, of the percentage distribution — 
by adjusted gross income (AGI) class — of the individual income 
tax saving resulting from the provision; 

A brief statement of the rationale for the adoption of the tax 
expenditure where it is known, including relevant legislative 
history; and 

References to selected bibliography. 

The information presented for each of these tax expenditures is not 
intended to be exhaustive or definitive. Rather, it is intended to pro- 
vide an introductory understanding of the nature, effect, and back- 
ground of each of these provisions. Good starting points for further 
research on each item are listed in the selected bibliography following 
each provision. 

Defining Tax Expenditures 

Tax expenditures are revenue losses resulting from Federal tax 
provisions that grant special tax relief designed to encourage certain 
kinds of behavior by taxpayers or to aid taxpayers in special circum- 
stances. These provisions may, in effect, be viewed as the equivalent 
of a simultaneous collection of revenue and a direct budget outlay of an 
equal amount to the beneficiary taxpayer. 

Section 3(a)(3) of the Congressional Budget and Impoundment 
Control Act of 1974 specifically defines tax expenditures as: 

.^ . . those revenue losses attributable to provisions of the Federal tax laws 
which allow a special exclusion, exemption, or deduction from gross income or 
which provide a special credit, a preferential rate of tax, or a deferral of tax 
liability; .... 

(1) 



In the legislative history of the Congressional Budget Act, provisions 
classified as tax expenditures are contrasted with those provisions 
which are part of the "normal structure" of the individual and cor- 
porate income tax necessary to collect government revenues. 

The concept of tax expenditures is relatively new, having been 
developed over only the past decade. Tax expenditure budgets which 
list the estimated annual revenue losses associated with each tax 
expenditure first were required to be published in 1975 as part of the 
Administration budget for FY 1976, and will be required to be 
published by the Budget Committees for the first time this April. 
The tax expenditure concept is still being refined, and therefore the 
classification of certain provisions as tax expenditures continues to 
be discussed. Nevertheless, there is widespread agreement for the 
treatment as tax expenditures of most of the provisions included 
in this compendium. 1 

The listing of a provision as a tax expenditure in no way implies 
any judgment about its desirability or effectiveness relative to other 
tax or nontax provisions that provide benefits to specific classes of 
individuals and corporations. Rather, the listing of tax expenditures, 
taken in conjunction with the listing of direct spending programs, is 
intended to allow Congress to scrutinize all Federal programs — both 
nontax and tax — when it develops its annual budget. Only if tax ex- 
penditures are included will Congressional budget decisions take into 
account the full spectrum of Federal programs. 

In numerous instances, the goals of these tax expenditures might 
also be achieved through the use of direct expenditures or loan 
programs. Because any qualified taxpayer may reduce tax liability 
through use of a tax expenditure, such provisions are comparable 
to entitlement programs under which benefits are paid to all eligible 
persons. Since tax expenditures are generally enacted as permanent 
legislation, it is important that, as entitlement programs, they be 
given thorough periodic consideration to see whether they are 
efficiently meeting the national needs and goals that were the reasons 
for their initial establishment. 

Major Types of Tax Expenditures 

Tax expenditures may take any of the following forms: (1) exclu- 
sions, exemptions, and deductions, which reduce taxable income; 
(2) preferential tax rates, which reduce taxes by applying lower 
rates to part or all of a taxpayer's income; (3) credits, which are 
subtracted from taxes as ordinarily computed; and (4) deferrals of 
tax, which result from delayed recognition of income or from allowing 
in the current year deductions that are properly attributable to a 
future year. 2 

The amount of tax relief per dollar of each exclusion, exemption, 
and deduction increases with the taxpayer's marginal tax rate. Thus, 
the exclusion of interest income from State and local bonds saves $50 
in tax for eve^ $100 of interest for the taxpayer in the 50 percent tax 
bracket, whereas the savings for the taxpa} r er in the 25 percent bracket 
is only $25. Similarly, the extra exemption for persons over age 65 and 



1 For a discussion of some of the conceptual problems involved in defining tax expenditures, see Budget 
of the United States Government, Fiscal year 1977, "Special Analysis F", 110-122. 
3 See Appendix A for further analysis of these types of tax expenditures. 



any itemized deduction is worth twice as much in tax saving to a 
taxpayer in the 50 percent bracket as to one in the 25 percent 
bracket. 

A tax credit is subtracted directly from the tax liability that would 
otherwise be due; thus the amount of tax reduction is the amount of 
the credit — which does not depend on the marginal tax rate. 

The numerous tax expenditures that take the form of exclusions, 
deductions, and exemptions are relatively more valuable to upper than 
to lower or middle income individuals. However, this fact should be 
viewed in the context of recent increases in the low-income allowance 
and in the standard deduction, which provide more tax saving for 
certain low-middle income taxpayers than itemized deductions, 
thus reducing the number of them who itemize. 

Moreover, even though some tax expenditures may provide most 
of their tax relief to those with high taxable incomes, this may be 
the consequence of overriding economic considerations. For example, 
tax expenditures directed toward capital formation may deliberately 
benefit savers who are primarily higher income taxpayers. 

Estimating Tax Expenditures 

The estimated revenue losses for all the listed tax expenditures 
have been provided by the Congressional Budget Office (CBO) based 
upon work done by the staffs of the Treasury Department and the 
Joint Committee on Internal Revenue Taxation. 3 Except for five 
expenditures, the estimates are identical to those that appear for 
the same provisions in the Administration's FY 1977 tax expenditure 
budget. 4 Most of these differences stem from CBO assumptions that 
certain tax expenditures scheduled to expire during 1976 will be con- 
tinued through FY 1977. 

In calculating the revenue loss from each tax expenditure, it is 
assumed that only the provision in question is deleted and that all 
other aspects of the tax system remain the same. In using the tax 
expenditure estimates, several points should be noted. 

First, in some cases, if two or more items were eliminated, the 
combination of changes would probably produce a lesser or greater 
revenue effect than the sum of the amounts shown for the individual 
items. 

Second, the amounts shown for the various tax expenditure items 
do not take into account any effects that the removal of one or more 
of the items might have on investment and consumption patterns 
or on any other aspects of individual taxpayer behavior, general 
economic activity, or decisions regarding other Federal budget outlays 
or receipts. 

Finahy, the revenue effect of new tax expenditure items added to 
the tax law may not be fully felt for several years. As a result, the 
eventual annual cost of some provisions is not fully reflected until 
some time after enactment. Similarly, if items now in the law were 
eliminated, it is unlikely that the full revenue effects would be im- 
mediately realized. 

3 The revenue estimates are based on the tax code as of January 1, 1976, with the exception that the tem- 
porary provisions applying to the investment credit, surtax exemption, earned income 
credit, and the standard deduction are estimated as if they will continue through FY 1977. 

* The Budget of the United States Government, Fiscal Year 1977, "Special Analysis F" at 125-127. 



However, these tax expenditure estimating considerations are similar 
to estimating considerations involving entitlement programs. Like 
tax expenditures, annual budget estimates for each transfer and income 
security program are computed separately. However, if one program, 
such as veterans' pensions, were either terminated or increased, this 
would affect the level of payments under other programs, such as 
welfare payments. Also, like tax expenditure estimates, the elimination 
or curtailment of a spending program, such as military spending or 
unemployment benefits, would have substantial effects on consumption 
patterns and economic activity that would directly affect the levels 
of other spending programs. Finally, like tax expenditures, the budge- 
tary effect of terminating certain entitlement programs would not 
be fully reflected until several years later because the termination 
of benefits is usually only for new recipients with persons already 
receiving benefits continued under "grandfather" provisions. 

Adjusted Gross Income Class Distributions 

Distributions of the tax benefits by adjusted gross income (AGI) 
class are given for almost all tax expenditures providing direct tax 
relief to individual taxpayers. These distribution figures show the por- 
tion of the total estimated revenue loss attributed to each tax expendi- 
ture that goes to all taxpayers with adjusted gross income falling within 
the boundaries of the respective income classes. No distribution to 
individual income classes is made of the tax expenditure benefits 
provided directly to corporations, since to do so would require un- 
substantiated assumptions concerning the ultimate beneficiaries 
of these corporate tax relief provisions. 

Taxable individual income tax returns falling within each AGI 
class for calendar 1974 were: 



AGI class 


Taxable returns 
(thousands) 


Percent of 

taxable returns 

in each class 


to $7,000.. 


19,909 


29.7 


$7,000 to $15,000. 


27,380 


40.9 


$15,000 to $50,000 


18,862 


28.2 


$50,000 and over 


815 


1.2 









The tax expenditure distributions by AGI class are taken from a 
study done by the Treasury Department in 1975 at the request of 
Senator Walter F. Mondale of Minnesota and are the most recent 
estimates of this type. 

These distributions indicate in a general way whether specific tax 
expenditures provide tax benefits largely to lower, middle, or high 
income taxpayers. However, adjusted gross income includes less 
than a fully comprehensive definition of income. It is total gross 
(non-exempt) income reduced by allowable deductions. Adjusted 
gross income will differ substantially from a more inclusive definition 
of money income where individuals have relatively large amounts of 
income which, pursuant to one or more tax expenditure provisions, 
are exempt from tax. For example, the exclusion of income earned b} 7 
certain U.S. citizens working or residing abroad (see p. 13) permits up 
to $25,000 a year of economic income to be excluded from adjusted 
gross income. Thus, many of the provision's beneficiaries will appear in 



the $0 to $7,000 AGI class, giving the appearance the provision largely 
benefits low income persons. However, in fact, many of these persons 
actually earned salaries in the area of $20,000 to $30,000. 

Order of Presentation 

The tax expenditures are presented in an order which parallels as 
closely as possible, the budget functional categories used in the Con- 
gressional budget, i.e., tax expenditures related to "national defense'' 
are listed first, and those related to "international affairs" are listed 
next. 

This order of presentation differs to a limited degree from that 
used in the tax expenditure budgets published by the Administration 
for 1976 and 1977 and prepared by the staffs of the Joint Committee on 
Internal Revenue Taxation and the Treasury Department for 1976. 
These budgets listed certain items under three headings — "business 
investment", personal investment", and "other tax expenditures" — 
that are not budget functional categories. However, in order that tax 
expenditures be presented in a manner which parallels as closely as 
possible the presentation of direct expenditures, the items that were 
listed under those three headings have been distributed in this com- 
pendium to the budget functional categories to which they are most 
closely related. This format is consistent with the requirement of 
Section 301(d)(6) of the Budget Act, which requires the tax expendi- 
ture budgets published by the Budget Committees as parts of their 
April 15 reports to present the estimated levels of tax expenditures 
"by major functional categories". 

Rationale 

The material on each tax expenditure contains a brief statement of 
the rationale for the adoption of the tax expenditure where it is known. 
These rationales are the principal ones which were publicly given at the 
time the provisions were enacted. 

Further Comment 

In the case of a number of tax expenditures, additional information is 
provided under the heading "Further Comment." It is material which 
either focuses attention on some of the principal issues related to a pro- 
vision or describes recent legislative proposals to amend a provision. 
This is material that does not fit within the other elements of the 
format of the compendium — either in the "Description," "Impact," or 
"Rationale" sections. As the examples which are provided in the 
descriptions of only some of the tax expenditures, the "Further 
Comment" sections are included only where they were deemed to be 
useful. Providing information under the "Further Comment" sections 
for only certain tax expenditures in no way implies any judgment about 
these provisions. 



EXCLUSION OF BENEFITS AND ALLOWANCES 
TO ARMED FORCES 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


. 650 
650 
650 




650 
650 
650 



Authorization 

Sections 112 and 113/ Regulation § 1.61-2, 2 and court decisions. 

Description 

Military personnel are not taxed on a variety of in-kind benefits 
and cash payments given in lieu of such benefits. These tax-free bene- 
fits include quarters and meals or — alternatively — cash allowances 
for these purposes, certain combat pay, and a number of less signifi- 
cant items. 

Impact 

All military personnel receive one or more of these benefits which 
are generally greater in the higher pay brackets. The amount of tax 
relief increases with the individual's tax bracket and therefore de- 
pends on a variety of factors unrelated to the taxpayer's military 
pay, such as other income including income from a spouse, and the 
amount of itemized deductions. Therefore, the exclusion of these bene- 
fits from taxation alters the distribution of net pay to service personnel. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 

Adjusted gross income class (thousands of dollars) : distribution 

Oto 7 46.9 

7 to 15 36. 2 

15 to 50 16. 2 

50 and over 0. 8 



1 The word "Section" denotes a section of the Internal Revenue Code of 1954 as amended 
unless otherwise noted. 

2 Reference to "regulations" are to Income Tax Regulations unless otherwise noted. 

(7) 



Rationale 

Although the principle of exemption of Armed Forces benefits 
and allowances appeared early in the history of the income tax, it 
has evolved through subsequent specific statute, regulations, revenue 
rulings, and court decisions. For some benefits, the rationale was a 
specific desire to reduce tax burdens of military personnel during 
wartime (as in the use of combat pay provisions) ; other preferences 
were apparently based on the belief that certain types of benefits 
were not strictly compensatory but rather an intrinsic element in the 
military structure. 

Further Comment 

Administrative difficulties and complications could be encountered 
in taxing some military benefits and allowances that are tax exempt; 
for example, it could be difficult to value meals and lodging when the 
option to receive cash is not available. However, eliminating the 
exclusions and adjusting pay scales accordingly might simplify 
decision-making about military pay levels and make "actual" salary 
more apparent to recipients. 

Selected Bibliography 

Binkin, Martin. The Military Pay Muddle, The Brookings Insti- 
tution, Washington, D.C., April 1975. 



EXCLUSION OF MILITARY DISABILITY 
PENSIONS 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal 


year 


Individuals 


Corporations 


Total 


1977__ 
1976__ 
1975 _ 




90 
80 
70 




90 
80 
70 









Authorization 

Section 104(a)(4) and Regulation §1.104-1 (e). 

Description 

Service personnel who have at least a 30-percent disability or who 
have at least 20 years of service and any amount of disability may 
draw retirement pay based on either percentage of disability or years 
of service. If the chosen pension is less than 50 percent of the basic 
pay, it will be raised to 50 percent during the first 5 years of retirement. 
Pay based on percentage of disability is fully excluded from gross 
income under Section 104. If pay is based on years of service, only 
the portion that would have been paid on the basis of disability is 
excluded from income. 

Impact 

Because it is exempt from tax, disability pay provides more net 
income than taxable benefits at the same level. The tax benefit of 
this provision increases as the pensioner's marginal tax rate increases. 
Thus, the after-tax pension benefits increase as a percentage of active 
duty pay as the individual's tax bracket increases. 

Estimated Distribution of Individual Income Tax Expenditure 
by Adjusted Gross Income Class 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

to 7 46. 2 

7 to 15 36.9 

15 to 50 16. 9 

50 and over 

Rationale 

The rationale for this exclusion is not clear. It was adopted in 1942 
during World War II. 

Selected Bibliography 

Binkin, Martin. The Military Pay Muddle, The Brookings Institu- 
tion, Washington, D.C., April 1975. 

(9) 



EXCLUSION OF GROSS-UP ON DIVIDENDS OF 
LESS DEVELOPED COUNTRY CORPORATIONS 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year Individuals Corporations Total 

1977 55 55 

1976 55 55 

1975 55 55 



Authorization 

Sections 78 and 902 and Executive Order No. 11071, December 27, 
1962. 

Description 

A domestic corporation that receives dividends from a foreign 
corporation in which the domestic corporation owns 10 percent or 
more of the voting stock may claim a foreign tax credit against its 
U.S. tax liability for the foreign income taxes paid by the subsidiary. 
If the foreign corporation is not a less developed country corporation 
(LDCC), the dividend must be "grossed-up" (i.e., increased) by the 
amount of foreign tax paid with respect to the dividend. The "grossed- 
up" amount is included in taxable income, and the U.S. tax rate is 
applied to the "grossed-up" taxable income to calculate the U.S. tax. 
The foreign tax may then be credited against (i.e., deducted from) the 
U.S. tax. However, dividends paid by LDCCs are not "grossed-up," 
but foreign taxes paid with respect to them are available as a foreign 
tax credit. To qualify as an LDCC, a corporation must have 80 per- 
cent or more of its gross income and assets connected with activities 
in less developed countries. Shipping companies with ships or aircraft 
registered in less developed countries qualify. Pursuant to Executive 
Order No. 11071 of December 27, 1962, all countries qualify as less 
developed except 16 Western European nations, Australia, New 
Zealand, South Africa, Canada, and Sino-Soviet bloc members. 

Example 

Assume the foreign tax rate is 24 percent, and an LDCC earns $100, 
pays a foreign tax of $24, and distributes the remaining $76 as a 
dividend. If "gross-up" is required, the U.S. tax before the credit is 
$48 (48 percent— the U.S. corporate tax rate— of $100) and the $24 

(ID 

67-312—76 2 



12 

foreign tax payment is credited against the $48 resulting in a $24 
U.S. liability after the credit. Thus, the total tax rate, including both 
the foreign and U.S. tax, is 48 percent which is equal to the U.S. rate. 
If "gross-up" is not required, then the U.S. tax is $36.48 (48 percent 
of $76) less $18.24 (24 percent of $76), which is the amount of the 
foreign tax paid on the dividend and which therefore can be credited. 
Thus, the net U.S. tax liability is $18.24, a total tax rate of 42.24 per- 
cent ($18.24 plus $24.00 divided by $100). Failure to "gross-up" 
therefore saves the parent corporation $5.76 ($24.00 — $18.24) of U.S. 
taxes. 

Impact 

Income remitted to parent companies by LDCCs is taxed at a 
lower rate than dividends from other subsidiaries. The amount of the 
benefit depends on the tax rate of the foreign country relative to the 
U.S. tax rate. The benefit is greatest when the foreign tax rate is half 
the 48 percent U.S. tax rate. In this case, the total U.S. and foreign 
tax is 42.24 percent (see the example above). The benefit declines as 
the foreign tax rate rises above or falls below half the U.S. tax rate; 
thus the net U.S. tax liability varies with the foreign effective tax 
rate. There is no benefit when the foreign tax rate equals or exceeds 
the U.S. tax rate and no benefit when the foreign tax rate is zero. 

Rationale 

The "gross-up" requirement for developed countries was added in 
1962. Prior to that time, "gross-up" was not required, and the method 
of computing the tax was derived from a 1942 Supreme Court decision 
{American Chicle Co. v. U.S., 316 U.S. 450) which interpreted the 
language of the provision allowing a foreign tax credit. While the 1962 
revision recognized that this provision should be corrected generally, 
the Finance Committee recommended exempting dividends from 
LDCCs from this requirement because it did not wish to discourage 
investment in such countries. 

Further Comment 

This preferential treatment for LDCC dividends would be elimi- 
nated by H.R. 10612, passed by the House in December 1975. 

Selected Bibliography 

Hellawell, Robert, "United States Income Taxation and Less 
Developed Countries: A Critical Appraisal," Columbia Law Review, 
December 1966, pp. 1393-4277. 

U.S. Congress, House, Committee on Ways and Means, General 
Tax Reform, Panel Discussions, 93rd Congress, 1st Sess., Part II — Tax 
Treatment of Foreign Income, February 28, 1973, pp. 1671-1881. 



EXCLUSION OF CERTAIN INCOME EARNED 
ABROAD BY U.S. CITIZENS 

Estimated Revenue Loss 





[In millions of dollars] 




F iscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


160 

145 

130 


160 
145 
130 



Sections 911-912. 



Authorization 



Description 



While U.S. citizens are generally taxable on their world-wide in- 
come, up to $20,000 of foreign earned income (largely salary income) 
may be excluded annually from income under section 911 by a citizen 
who (1) is a bona fide resident of a foreign country for an uninterrupted 
period that includes a taxable year, or (2) has been present in a foreign 
country for 510 days (17 months) out of 18 consecutive months. The 
annual exclusion is raised to $25,000 for an individual who has been a 
bona fide resident of a foreign country for at least 3 consecutive years. 
Section 911 does not apply to salaries received from the U.S. Govern- 
ment. 

Section 912 exempts from tax certain allowances that are received by 
Federal civilian employees working abroad. The principal exempt 
allowances are for high local living costs, education, and housing. 

Impact 

Some U.S. citizens living abroad pay no income taxes to the coun- 
tries in which they reside. Section 911 allows their income up to the 
appropriate ceiling to be tax free in the United States as well. 

In cases where U.S. citizens pay foreign income taxes, those taxes, 
including the taxes paid on the income excluded from taxation under 
this section, can be credited against any U.S. tax liability that would 
otherwise exist on other foreign income: earned income above the 
$20,000 or $25,000 excludable limits and investment income. This 
allows U.S. taxpayers to offset all the foreign tax — including that paid 
on the amount of excluded income — against U.S. tax that, would 
otherwise be due on the income in excess of the excluded amount. 
Thus, the combination of the exclusion and the foreign tax credit can 
result in levels of income actually exempt from U.S. tax in excess of the 
stated limits. 

(13) 



14 

In addition to the U.S. citizens who directly benefit from this 
favorable treatment, overseas employers also benefit to the extent 
that salary levels are lower because of the exclusion. To the ex- 
tent this occurs, they maintain an advantage relative to domestic 
employers. U.S. corporations that bid on overseas construction proj- 
ects assert that the salary savings make them more competitive with 
foreign bidders, some of the employees of which also enjoy similar 
salary savings. 

The value of the Section 912 exemption for allowances received by 
Federal civilian employees working abroad increases with the re- 
cipient's tax bracket. The value therefore depends on a variety of 
factors including the level of the recipient's Federal salary, the extent 
of his other income, and the amount of his itemized deductions. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Adjusted gross income class (thousands of dollars) : distribution 

0to7 38. 9 

7 to 15 17.8 

15 to 50 34.4 

50 and over 8. 9 

Rationale 

A less restrictive form of Section 911 was first enacted in 1926 
to encourage foreign trade. After World War II, the exclusion was 
justified as part of the Marshall Plan to encourage persons with 
technical knowledge to work abroad. Although the provision was 
revised on several occasions, dollar limitations were first enacted in 
1953 at $20,000 and $35,000. The latter figure was reduced to $25,000 
in 1964. 

The exemption for civilian Federal employee overseas allowances 
was enacted in 1943. The principal rationale was to provide additional 
compensation for these employees, who were performing vital wartime 
services. 

Further Comment 

H.R. 10612 passed by the House of Representatives in December 
1975 would phase out Section 911 over a 3-year period. However, it 
would provide a new tax deduction for amounts paid as tuition for 
children of U.S. citizens working abroad. 

Selected Bibliography 

U.S. Congress, House, Committee on Ways and Means, General 
Tax Reform, Panel Discussion, 93rd Congress, 1st Session, Part II — 
Tax Treatment of Foreign Income, February 28, 1973, pp. 1671-1888. 



DEFERRAL OF INCOME OF DOMESTIC INTER- 
NATIONAL SALES CORPORATIONS (DISCs) 



Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


1,420 

1,340 

1,130 


1,420 
1,340 
1, 130 



Sections 991-997. 



Authorization 



Description 



Corporations qualifying as DISCs (Domestic International Sales 
Corporations) must be incorporated in the United States, at least 95 
percent of their assets must be related to export functions, and at 
least 95 percent of their gross receipts must stem from export sale or 
lease transactions. 

DISCs typically are wholly owned subsidiary corporations through 
which parent corporations channel their export sales. DISCs are 
not themselves subject to corporate income tax, but their parent 
corporations are taxed on the DISC income when it is distributed or 
attributed to them. 

The tax savings from using a DISC result principally from two 
interrelated aspects of the tax law: (1) the allocation rules that allow at 
least half of the total, combined profit of the parent and DISC from 
export sales to be attributed to the DISC, and (2) the potentially 
permanent tax deferral that is allowed on half of those profits attributed 
to the DISC under the liberal allocation rules. The other half of a 
DISCs income is either actually or deemed to be distributed annually 
to its parent corporation and thus does not qualify for deferral. 

The allocation rules provide that a DISC is deemed to have earned 
either: (1) 50 percent of the combined taxable income of the parent 
corporation and DISC from export sales or (2) 4 percent of the gross 
receipts from the export sales, whichever is greater. The 50 percent 
allocation is used much more frequently. The rules for allocating 
DISC profits are much more favorable than the otherwise applicable 
tax law standard (Section 482) which requires a sale by a manufac- 
turer or producer to a wholly owned sales subsidiary to be at an arm's 
length price. If the Section 482 rule were applied to DISCs, only a 
relatively small, or no, sales commission would be allocated to the 

(15) 



16 

DISC, while the proportionately larger profits from production would 
go to the parent corporation. 

The deferral of tax (on 50 percent of the income allocated to the 
DISC) continues as long as the undistributed DISC income is invested 
in qualified assets; the duration may be indefinite, and in such cases 
constitutes the practical equivalent of a permanent tax exemption. 

Example 

Assume a company incurs total costs of $8,000 in producing goods 
selling on the export market for $10,000. The allocation rule attributes 
50 percent of the $2,000 total net profit to the DISC and 50 percent 
to the parent firm. Taxes are deferred on $500 of the $1,000 allocated to 
the DISC and the 48 percent corporate tax rate is applied to the 
remaining $1,500 of direct profits and DISC earnings attributed or 
paid to the parent firm. The total tax liability is $720. If a DISC had 
not been used, the tax liability would have been $960 ($2,000 X .48 
tax rate). The DISC provides a tax savings of $240 ($500 of deferrable 
DISC income X .48 tax rate) and, therefore, lowers the effective tax 
rate to 36 percent on this export sales income. 

Impact 

This provision reduces the marginal tax rate on DISC-related 
export income from 48 percent to 36 percent (and to 24 percent in the 
relatively few cases where the total profit on export sales of the DISC 
and its parent is no more than 4 percent of gross export receipts). 

Whether U.S. exporters reduce export prices in response to reduced 
effective tax rates is unclear. To the extent they do, foreign purchasers, 
as well as domestic exporters, would be subsidized. 

According to several studies, the overall impact of DISC in stimu- 
lating exports has been small in comparison to its annual revenue 
cost. U.S. exports have increased dramatically since the DISC 
provisions were added, but the increase is said to be due to the devalu- 
ations of the dollar, worldwide inflation, and a stable U.S. share of 
expanding worldwide trade. On the other hand, many companies which 
utilize DISC argue it should be retained because: (1) in their view, 
DISC has substantially increased exports which, in turn, have in- 
creased U.S. employment levels; and (2) other countries emplo} T a 
variety of export promotion devices. 

Corporations with profitable export operations benefit from the tax 
reduction. The Treasury Department study cited below in the bibliog- 
raphy reported that 72 percent of the net income of 1,510 DISCs with 
corporate owners for which asset size data were available accrued to 
186 companies with gross assets in excess of $250 million, with 44 per- 
cent going to only 28 companies. 

Rationale 

Originally adopted as part of the Revenue Act of 1971, the stated 
purpose of DISC was to stimulate exports and enhance the attractive- 
ness of domestic manufacturing vis-a-vis manufacturing through for- 
eign subsidiaries. 



Further Comment 

H.R. 10612, passed by the House in December 1975, would reduce 
current DISC benefits by roughly one-third by limiting income 
qualifying for deferral to that earned by exports in excess of 75 percent 
of a company's exports during a prescribed base period. 

Selected Bibliography 

U.S. Congress, House, Committee on Ways and Means, General 
Tax Reform, Panel Discussions, 93rd Congress, 1st Session, Part II — 
Tax Treatment of Foreign Income, February 28, 1973, pp. 1671-1880. 

U.S. Congress, Senate, Task Force on Tax Policy and Tax Expendi- 
tures, Committee on the Budget, Seminar — DISC: An Evaluation oj 
the Costs and Benefits, Committee Print, November 1975. 

U.S. Department of Treasury, "The Operation and Effect of the 
Domestic International Sales Corporation Legislation," 1973 Annual 
Report, April 1975, 30 pages. 



SPECIAL RATES FOR WESTERN HEMISPHERE 
TRADE CORPORATIONS 



Estimated Revenue Loss 





[In millions of 


dollars] 




Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 





50 
50 
50 


50 
50 
50 



Sections 921 and 922. 



Authorization 



Description 



Western Hemisphere Trade Corporations (WHTCs) are granted a 
special deduction which has the effect of reducing the tax rate by 
as much as 14 percentage points. 1 The amount of the special deduction 
is the taxable income of the corporation (before the special deduction) 
multiplied by a fraction, the numerator of which is 14 percent and the 
denominator of which is the overall rate (i.e. the sum of the normal 
tax rate and the surtax rate) on the corporation's total taxable income. 

A WHTC is a U.S. corporation: (1) all of whose business is done 
in the Western Hemisphere; (2) 95 percent or more of whose income 
over the last three years was derived from sources outside the U.S.; 
and (3) 90 percent or more of whose income over the same three years 
was derived from the active conduct of a trade or business. 

WHTCs may not defer U.S. taxation of their income (as in the 
case of a controlled foreign corporation), but they may take a tax 
credit for foreign taxes imposed on that income. The WHTC deduction 
may not be taken for a taxable year in which the corporation is a 
Domestic International Sales Corporation (DISC) or in which it 
owns any stock in a DISC or former DISC. 

Example 

If taxable income is $100,000 when computed without regard to 
the WHTC deduction, the WHTC deduction equals $100,000 X (14 
percent/48 percent) =$29,166.67; taxable income is reduced to 



1 Under the permanent corporate rate structure, the full 14 percentage point reduction applies to 
all WHTCs with income in excess of $35,294. Corporations with less income obtain a deduction which will 
reduce their tax rate by less than 14 percentage points. Under the temporary tax reductions in the Tax 
Reduction Act of 1975 and the Revenue Adjustment Act of 1975 which expire on June 30, 1976, the principle 
remains the same, but the cut-off figure for the full 14 percent reduction is slightly higher. 

(19) 



20 

$70,833.34, and tax liability on this amount is $27,500 (assuming a 
22% rate on the first $25,000 of taxable income and a 48% rate on 
the income in excess of $25,000). Without this special deduction the 
tax would have been $41,500. Thus, the effective tax rate has been 
reduced by 14 percentage points. 

Impact 

For many companies, tax deferral through foreign incorporation 
has been more advantageous than the WHTC provision. But, because 
only domestic corporations may take percentage depletion, com- 
panies with Western Hemisphere extractive industry operations out- 
side the U.S. were traditionally organized as WHTCs. Currently, 
however, the WHTC provision yields little or no tax saving for such 
operations because the application of large foreign tax credits com- 
pletely or nearly completely offsets any U.S. tax liability. 

The WHTC provision also has been used by sales subsidiaries. 
However, the more recent DISC legislation can be more valuable 
in many cases, and the absence of growth in use of WHTCs may 
reflect replacement of WHTC sales subsidiaries by DISCs. 

Rationale 

The Revenue Act of 1942 enacted the WHTC provisions to exempt 
a few corporations then engaged in operations outside the United 
States but within the Western Hemisphere from the high wartime cor- 
porate surtaxes. The current provisions were continued in 1950 when 
the tax structure was changed. The WHTC treatment is now justified 
by some persons as necessary to maintain the competitive position 
of corporations competing in the Western Hemisphere with foreign 
corporations. 

Further Comment 

H.R. 10612, passed by the House of Representatives in December 
1975, would phase out this provision by the end of taxable years 
that begin in 1980. 

Selected Bibliography 

Musgrave, Pegg} T , "Tax Preferences to Foreign Investment" in 
U.S. Congress, Joint Economic Committee, The Economics of Federal 
Subsidy Programs, Part 2 — International Subsidies, 92nd Congress, 
2nd Session, July 15, 1972, p. 195. 

Surrey, Stanley S., "Current Issues in the Taxation of Corporate 
Foreign Investment", Columbia Law Review, June 1956, pp. 830-838. 

U.S. Congress, House Committee on Ways and Means, General 
Tax Reform, Panel Discussion, Part II — Tax Treatment of Foreign 
Income, 93rd Congress, 1st Session, February 28, 1973, pp. 1671-1888. 

U.S. Congress, Joint Committee on Internal Revenue Taxation, 
U.S. Taxation of Foreign Source Income oj Individuals and Corpora- 
tions and the Domestic International Sales Corporation Provisions, 
September 29, 1975. 



DEFERRAL OF INCOME OF CONTROLLED 
FOREIGN CORPORATIONS 



Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


365 

525 

590 


365 
525 
590 



Authorization 

Sections 11(f), 882, and 951-964. 

Description 

A U.S. corporate parent of a foreign subsidiary is not taxed on the 
income of that subsidiary until the income is remitted (or "repatri- 
ated") to the parent. The deferral of U.S. tax liability on the sub- 
sidiary's income is permanent to the extent that the income is rein- 
vested in the subsidiary or other foreign subsidiaries rather than 
remitted to the U.S. parent. A tax credit in the amount of foreign 
taxes paid on repatriated income, plus any "gross up" required (see 
page 11), is allowed at the time of repatriation. 

On the other hand, income from foreign branches (as distinguished 
from subsidiaries) of U.S. corporations is taxed on a current basis 
since the branches are parts of U.S. corporations. Certain so-called 
tax haven income also is taxed currently in the U.S. irrespective of 
whether earned by a foreign subsidiary or a branch. The Tax Reduc- 
tion Act of 1975 strengthened the provisions requiring current taxation 
of such income. 

Impact 

Companies that operate in countries with effective income tax rates 
less than the U.S. rate may receive tax benefits from this provision. 

A substantial portion of the revenue loss is attributable to deferral 
on shipping income, which is estimated to account for over S100 
million of the current revenue loss. This occurs because shipping firms 
are often based in countries without income taxes, such as Liberia and 
Panama^ U.S. Department of Commerce data indicate that 423 of the 
678 foreign flag ships owned by U.S. corporations and their sub- 
sidiaries are registered in Panama or Liberia. Much (485) of this total 
shipping fleet is composed of tankers. 

(21) 



22 

Rationale 

Historically, the United States has not taxed foreign source income 
of foreign corporations on the premise that only domestic corporations 
or income with a U.S. source is subject to U.S. jurisdiction. In effect, 
the separate corporate status of foreign subsidiaries of domestic 
corporations was respected. In 1962 these principles were abrogated 
for certain so-called tax haven income under subpart F of the Code. 
Such income is taxed even though earned abroad and even though 
not repatriated. 

Further Comment 

Opponents of deferral allege it encourages investment in foreign 
countries and reduces domestic investment, thus reducing U.S. tax 
revenues and U.S. exports, and adversely affecting the balance of 
payments, the balance of trade, and domestic employment. Pro- 
ponents deny such allegations and argue that deferral must be con- 
tinued for U.S. corporations to remain competitive with foreign 
companies in overseas markets. 

Deferral of tax on foreign profits is not neutral compared to invest- 
ment in the United States in the sense that if the foreign country 
tax rate is less than the U.S. tax rate and the income is not going to 
be repatriated, a U.S. corporation has a tax incentive to invest abroad 
using a foreign subsidiary instead of investing at home. However, 
the deferral rules do neutralize advantages foreign competitors 
may have over U.S. corporations operating abroad. Moreover, 
there are also offsetting tax rules which favor investment in the U.S. 
by domestic companies rather than abroad such as the general limita- 
tion of the investment credit and asset depreciation range (ADR) 
depreciation to assets used in the United States. 

Selected Bibliography 

Krause, Lawrence B. and Kenneth W. Dam. Federal Tax Treat- 
ment of Foreign Income, The Brookings Institution, Washington, D.C 
1964, 145 pages. 

Musgrave, Peggy, "Tax Preferences to Foreign Investment," 
in U.S. Congress, Joint Economic Committee, The Economics of 
Federal Subsidy Programs, Part 2 — International Subsidiaries, 92nd 
Congress, 2nd Session, July 15, 1972, pp. 176-219. 

U.S. Congress, House, Committee on Wa}s and Means, General 
Tax Reform, Panel Discussions, 93rd Congress, 1st Session, Part II — 
Tax Treatment of Foreign Income, February 28, 1973, pp. 1671-1881. 

U.S. Congress, House, Committee on Ways and Means, U.S. 
Taxation of Foreign Income — Deferral and the Foreign Tax Credit, 
Prepared by the Joint Committee on Internal Revenue Taxation, 
Committee Print, September 27, 1975. 

U.S. Taxation of American Business Abroad. An Exchange of Views, 
A.E.I. — Hoover Policy Studies, American Enterprise Institute, 
Washington, D.C, 1975, 101 pages. 



AGRICULTURE: EXPENSING OF CERTAIN 
CAPITAL OUTLAYS 



Estimated Revenue Loss 







[In millions of dollars] 




Fiscal 


year 


Individuals 


Corporations 


Total 


1977._ 




360 
355 
475 


115 
105 
135 


475 


1976.. 
1975__ 




460 
610 



Authorization 

Sections 162, 175, ISO, 182, 278 and Regulations §§ 1.61-4, 1.162-11, 
and 1.471-6. 

Description 

Farmers may use the cash method of tax accounting to deduct costs 
attributable to goods held for sale and in inventory at the end of the 
tax year. They are also allowed to expense (i.e., deduct when they are 
incurred) some costs of developing assets that will produce income in 
future years. Both of these rules deviate from generally applicable 
tax accounting rules, which do not permit deduction of inventory costs 
until the inventory is sold, and which require the cost of income- 
producing assets to be deducted over their useful lives. These rules 
thus allow farmers to claim deductions before realizing the income 
associated with the deductions. 

Items that may be deducted before income from them is realized in- 
clude cattle feed, expenses of planting crops for the succeeding year's 
harvest, and development costs such as those incurred in planting 
vineyards and fruit orchards. There are special restrictions on the 
expensing of farming outlays for citrus and almond groves. 

In addition, the statute allows expensing of certain items that 
otherwise might be considered capital expenditures rather than 
current expenses. These items include expenses for soil and water 
conservation (Section 175), land clearing (Section 182), and fertilizer 
(Section 180). 

Impact 

The effect of deducting costs before the associated income is realized 
is the understatement of income in that year followed by an over- 
statement of income when it is realized. The net result is that tax lia- 
bility is deferred from the time the deduction is taken to the period 
of the asset's remaining useful life. This affords the taxpayer an 
interest-free loan in the amount of the deferred tax. When the income 

(23) 



24 

is finally taxed, it may be taxed at preferential capital gains rates 
(see p. 25 below). 

The expensing of capital outlays is available to all taxpayers who 
have farm investments. Therefore, these rules provide a tax subsidy 
for all farming operations, and particularly for those with a long de- 
velopment period (such as orchards and vineyards) . 

Concern has focused on the use of farming as a tax shelter by high 
income bracket individuals who seek to offset their nonfarm taxable 
income with large, artificial, farming losses. Such investment packages 
normally have been characterized by a highly leveraged capital structure. 
To a high income taxpayer, this translates into a relatively riskless 
investment, since tax savings generated through the deduction of 
losses may return most or all of the initial cash outlay in the first year 
of operation. 



Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class* 

Percentage 

Adjusted gross income class (thousands of dollars) : distribution 

to 7 18. 1 

7 to 15 35. 3 

15 to 50 33. 6 

50 and over 12. 9 

1 The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting 
from these tax provisions is not reflected in this distribution table. 

Rationale 

The special rules with respect to development costs and cash ac- 
counting were established in regulations issued very early in the de- 
velopment of the tax law. At that time, because accounting methods 
were less sophisticated, tax rates were low T , and the typical farming 
operation was small, the regulations apparently were adopted to 
simplify record keeping for the farmer. The statutory rules permitting 
deductions for soil and water conservation, land clearing expenses, and 
fertilizer costs were added between 1954 and 1962 to encourage con- 
servation practices. The special restrictions on the expensing of fann- 
ing outlays for citrus and almond growers were enacted in 1969. 

The current use of cash basis accounting for farmers is justified 
by its proponents as much simpler, and more workable and consistent 
than the accrual method. 

Selected Bibliography 

U.S. Congress, House, Committee on Ways and Means, Panel 
Discussion on General Tax Reform, Part 5 — Farm Operations, Febru- 
ary 8, 1973, pp. 615-96. 

U.S. Congress, House, Joint Committee on Internal Revenue 
Taxation, Tax Shelters: Farm Operations, Prepared for the Use of the 
Committee on Ways and Means, September 6, 1975, 25 pages. 

U.S. Congress, House, Committee on Ways and Means, Tax Re- 
form Hearings. Tax Reform, Part 2 — Farm Operations, July 15, 1975, 
pp. 1360-1402. 



AGRICULTURE: CAPITAL GAIN TREATMENT 
OF CERTAIN INCOME 



Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


565 40 
490 30 
455 30 


605 
520 

485 



Authorization 

Sections 1201-1202, 1221-1223, 1231, 1245, and 1251-1252, 

Description 

If gains from the sale or exchange of property used in a trade or 
business exceed losses from such property in any year, the gain is 
treated as long term capital gain. Real estate or depreciable property 
used in farming operations and held for more than six months, but not 
held for sale, generally qualifies as such property. However, horses and 
cattle qualify only if they have been held more than 24 months, and all 
other livestock, more than 12 months. 

In some cases, all or much of the cost of the farm property used in the 
business has previously been deducted under the farm accounting rules 
discussed on page 23. Consequently, in 1969, Congress enacted legisla- 
tion to tax as ordinary income some gains previously taxed as capital 
gain. These gains are principally those from the sale of (a) land held for 
less than ten years, but only to the extent of previously deducted soil 
and water conservation expense, and (b) farm property, to the extent 
that prior farm losses exceeded $25,000 in any year in which the tax- 
payer had nonfarm income in excess of $50,00b. 

Impact 

Subject to these rules, taxpayers owning farm assets may obtain long 
term capital gain treatment on qualifying assets even though much of 
the asset cost has been deducted against ordinary income. While this 
favorable tax treatment is limited to property used in the farming 
business, many farm assets have a dual potential of being held for sale 
or for use in the business. Assets having this ambiguous nature are 

(25) 



26 

often sold before the ambiguity is resolved, and the gain is treated as 
capital gain. Over 90 percent of the tax saving is claimed by non- 
corporate farmers. The tax benefit per dollar of capital gain increases 
with the taxpayer's marginal tax rate. The interaction between the 
deduction of costs and capital gain treatment for the sale of such assets 
has resulted in many tax shelter operations in farming. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 1 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

0to7 18.3 

7 to 15 35. 6 

15 to 50 33. 7 

50 and over 12. 5 

1 The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting 
from these tax provisions is not reflected in this distribution table. 



Rationale 

Preferential treatment for capital gains for individuals was intro- 
duced in 1921. However, long term capital gain treatment for property 
used in a trade or business was not enacted until 1942. Between 1942 
and 1951, there was a dispute whether livestock qualified as such 
property, and legislation in 1951 gave livestock that status. The 1942 
legislation was enacted to provide tax relief for war-related gains. 

Further Comment 

Many proposals for changing the present law have been made from 
time to time. They include proposals to limit or eliminate the expensing 
of capital outlays, to impede tax shelter operations, to lengthen the 
holding periods for farm assets, and to change the definition of quali- 
fying property. 

Selected Bibliography 

Carlin, Thomas A. and W. Fred Woods. Tax Loss Farming, 
ERS-546, Economic Research Service, U.S. Department of Agri- 
culture, April 1974. 

U.S. Congress, House, Committee on Ways and Means, General 
Tax Reform. Panel Discussions. Part 5 — Farm Operations, February 
8, 1973, pp. 615-96. 

U.S. Congress, House, Joint Committee on Internal Revenue 
Taxation, Tax Shelters: Farm Operations. Prepared for the Use of 
the Committee on Ways and Means, September 6, 1975, 24 pages. 

U.S. Congress, Committee on Ways and Means, Tax Reform. 
Hearings. Part 2— Farm Operations, July 15, 1975, pp. 1360-1402. 



EXPENSING OF INTANGIBLE DRILLING, 
EXPLORATION AND DEVELOPMENT COSTS 



Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


195 840 
155 650 
120 500 


1, 035 
805 
620 



Authorization 

Sections 263(c) and 616-617. 

Description 

Taxpayers engaged in drilling for oil and gas may deduct in- 
tangible drilling costs as incurred while taxpayers engaged in other 
mining activities may deduct exploration and development costs 
as incurred (i.e., these costs may be "expensed";. 

Intangible drilling costs are certain expenses incurred in bringing 
a well into production, such as labor, materials, supplies and repairs. 
Expenses for tangibles such as tanks and pipes are recovered through 
depreciation. 

Mining exploration costs are those for the purpose of ascertaining 
the existence, location, extent or quality of a deposit incurred before 
the development stage, such as core drillings and testing of samples. 
nnnThese expenses are limited in the case of foreign exploration. For- 
eign exploration costs cannot be expensed after the taxpayer has total 
foreign and domestic exploration costs of $400,000. Development 
expenses include those incurred during the development stage of 
the mine such as constructing shafts and tunnels and in some cases 
drilling and testing to obtain additional information for planning 
operations. There are no limits on the current deductibility of such 
costs. Although both intangible drilling costs and mine development 
costs may be taken in addition to percentage depletion, mining 
exploration costs subsequently reduce percentage depletion deductions. 
In the case of mines, there are also ''recapture" provisions under 
which capital gains from the sale of the property are taken as ordinary 
income to the extent of prior deductions for exploration expenses. 

(27) 



:2- 



28 

Impact 

Generally, expenditures which improve assets that yield income 
over several years must be capitalized and deducted over the period 
in which the assets produce income. The tax advantage of treating 
these expenditures as current expenses is the same as any other 
allowing premature deductions; the taxpayer is allowed to defer cur- 
rent tax liabilities; this treatment amounts to an interest-free loan 
(see Appendix A) . 

These expensing provisions are additional benefits which supple- 
ment the special percentage depletion allowances extended to the 
mineral industry. 1 Although the expensing and depletion provisions 
operate somewhat independently, a firm or person may be eligible 
for both and receive their combined benefits. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 1 

Percentage 

Adjusted gross income class (thousands of dollars) : distribution 

to 7 2. 5 

7 to 15 15.0 

15 to 50 33. 8 

50 and over 48. 8 

1 The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting 
from these tax provisions is not reflected in this distribution table. 

Rationale 

The option to expense intangible drilling costs (as well as dry hole 
costs) of oil and gas wells developed through regulations issued in 
1917 (19 Treas. Dec, Int. Rev. 31 (1917)). These regulations reflected 
the view that such costs were ordinary operating expenses. In 1942, 
the Treasury Department recommended that the provisions be re- 
moved, but Congress did not consider the suggestion. (Hearings on 
Revenue Revision of 1942 before the Committee on Ways and Means, 
p. 2996, Vol. 3, 77th Cong., 2nd Sess.) In 1945, when a "court decision 
invalidated the regulations (F.H.E. Oil Co. v. Commissioner, 147 F.2d 
1002, 5th Cir. 1945), Congress adopted a resolution (H. Con. Res. 50, 
79th Cong., 1st Sess.) approving the treatment and later incorporated 
it into law in the 1954 Code. The legislative history of this resolution 
indicates that it was intended to reduce uncertainty in mineral ex- 
ploration and stimulate drilling for military and civilian purposes. 
(TI. Rep. No. 761, 79th Cong., 1st Sess./ pp. 1-2.) Expensing of 
mine development expenditures was enacted in 1951 to reduce am- 
biguity in current treatment and encourage mining. The provision 
for mine exploration was added in 1966. 

Prior to the Tax Reform Act of 1969, a taxpayer could elect either 
to deduct without dollar limitation exploration expenditures in the 
United States, which subsequently reduced percentage depletion bene- 
fits, or to deduct up to $100,000 a year with a total not to exceed 
$400,000 of foreign and domestic exploration expenditures without the 
application of the recapture rule. The 1969 Act subjected all post-1969 
exploration expenditures to recapture. 

1 1 'ercentage depletion has boon eliminated for larger producers of oil and gas and is being reduced for other 
producers; see pages 31-32, below. 



29 

Selected Bibliography 

Agria, Susan, "Special Tax Treatment of Mineral Industries," in 
The Taxation of Income from Capital, The Brookings Institution, 
Washington, D.C., 1969, pp. 77-122. 

U.S. Congress, Senate, Committee on Interior and Insular Affairs, 
An Analysis of the Federal Tax Treatment of Oil and Gas and Some 
Policy Alternatives, 1974, 58 pages. 



EXCESS OF PERCENTAGE OVER COST 
DEPLETION 



Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


575 1, 020 
500 1, 080 
465 2, 010 


1,595 
1, 580 
2,475 



Section 613. 



Authorization 
Description 



Most firms engaged in oil, gas, and other mineral extraction are 
permitted to include in their business costs a "depletion" allowance for 
the exhaustion of the mineral deposits. Depletion is similar in concept 
to depreciation. The depletion allowance is used to recover the cost of a 
mineral deposit. There are two methods of calculating depletion: 
percentage depletion and cost depletion. Taxpayers who qualify for 
percentage depletion must use it if it is greater than cost depletion. 

Under percentage depletion, a taxpayer deducts a fixed percentage 
of gross income from mining as a depletion allowance regardless of the 
amount invested in the deposit. The deduction for gas and oil (which 
was 27.5 percent from 1926-69) is now set at 22 percent. However, 
beginning in 1975 the percentage depletion allowance was repealed 
for major oil and gas companies. Other companies (independents) 
have been exempted from repeal of 2,000 barrels a day for 1975. The 
amount of this exempt portion is being phased down gradually to 
1,000 barrels a day. In addition, beginning in 1981, the depletion rate 
will be gradually phased down to 15 percent for qualiiAung producers. 

Percentage depletion also applies to other mineral resources at 
percentages currently ranging from 22 percent to 5 percent. Sulphur, 
uranium, and most other metals mined in the United States qualify 
for the 22 percent rate; however, domestic gold, silver, and iron ore 
qualify for a 15 percent rate; most minerals mined outside the U.S. 
qualify for a 14 percent rate; coal qualifies for a 10 percent rate; and 
several forms of clay, gravel, and stone qualify for 5 and 7}i percent 
rates. 

Percentage depletion may not exceed 50 percent of the net income 
from the property. This limitation is known as the "net income 
limitation." The total cost which can be recovered by percentage 
depletion is not limited to the cost of the property. 

(31) 



32 

Cost depletion resembles depreciation based upon the number of 
units produced. The share of the original cost deduction each year is 
equal to the portion of the estimated total production (over the life- 
time of the well or mine) which is produced in that year. Using cost 
depletion, capital recovery cannot exceed the initial cost. 

The value of the percentage depletion provision to the taxpayer is 
the amount of tax savings on the excess of the percentage depletion 
over cost depletion. 

Impact 

Issues of principal concern are the extent to which percentage 
depletion: (1) decreases the price of qualifying oil, gas and other 
minerals, and therefore encourages their consumption; (2) bids up 
the price of drilling and mining rights; and (3) encourages the develop- 
ment of new deposits and increases production. 

Most analyses of percentage depletion have focused on the oil and 
gas industry, which prior to 1975 accounted for the bulk of percentage 
depletion. Since 1975 legislation repealed the percentage depletion 
allowance for most oil and gas production, only one-quarter of 
oil and gas production is estimated to be currently eligible for per- 
centage depletion. Sales of all other mineral deposits were unaffected 
by the 1975 legislation. 

Because of the prior focus on oil and gas percentage depletion, 
there has been relatively little analysis of the impact of percentage 
depletion on other industries. The relative value of the percentage 
depletion allowance in reducing the effective tax rate of mineral 
producers is dependent on a number of factors, including the statutory 
percentage depletion rate, the effect of the net income limitation, and 
the basic cost structure of the industry. For example, the greater 
the mining cost as a percentage of the selling price of the final mineral 
product, the greater the value of percentage depletion to the industry. 
This effect may account in part for the greater value of percentage 
depletion to the copper industry, as reported in SEC data as compared 
to the aluminum industry — since the mining of bauxite constitutes a 
much smaller portion of the cost of producing aluminum than the 
mining of copper does to the cost of finished copper. 

In the past, the net income limitation kept the effective percentage 
depletion rate for coal at around 6 percent although the statutory 
rate is 10 percent. Because the rising price of imported oil has in- 
creased the average price of all oil, coal has been substituted for oil, 
resulting in dramatic increases in the price of coal. The price in- 
creases will make the net income limitation inapplicable to much 
coal production, so the effective depletion rate is likely to rise to nearly 
the statutory rate. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 1 

T^cTCCixtaoc 

Adjusted gross income class (thousands of dollars) : distribution 

0to7 3.3 

7 to 15 9.8 

15 to 50 31. 8 

50 and over 55. 1 

1 Tlio distribution refers to the individual tax expenditure only. The corporato tax expenditure resulting 
from these tax provisions is not reflected in this distribution table. 



33 

Rationale 

Deductions in excess of depletion based on cost were first allowed 
in 1918 in the form of "discovery value depletion'' which allowed 
depletion on the market value of the deposit after discovery rather 
than on its cost. The purpose was to stimulate exploration during 
wartime and to relieve the tax burdens on small scale prospectors. 
Treasury believed that taxpayers often established high discovery 
values and thus claimed excessive depletion. In 1926, to avoid the 
administrative problems raised by the need to establish market value, 
Congress substituted percentage depletion for oil and gas properties. 
Beginning in 1932 percentage depletion was extended to most other 
minerals. 

In 1950, President Truman recommended the reduction of percent- 
age depletion to a maximum of 15 percent, but Congress failed to take 
action on this recommendation. Only minor changes were made until 
1969 when the depletion allowance for oil and gas was reduced from 
27.5 percent to 22 percent, and "excess" depletion was made subject 
to the minimum tax beginning in 1970. 

Selected Bibliography 

Agria, Susan, "Special Tax Treatment of Mineral Industries/' in 
The Taxation of Income from Capital, The Brookings Institution, 
Washington, D.C., 1969, pp. 77-122. 

U.S. Congress, Senate Committee on Interior and Insular Affairs, 
An Analysis of the Federal Tax Treatment of Oil and Gas and Some 
Policy Alternatives, 1974, 58 pages. 



CAPITAL GAIN TREATMENT OF ROYALTIES 
ON COAL AND IRON ORE 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 


50 


20 


70 


1976 


45 


15 


60 


1975 


40 


10 


50 



Section 631(c), 



Authorization 



Description 



Lessors of coal and iron ore deposits (which have been held more 
than 6 months prior to disposition or lease) in which they retain an 
economic interest may treat royalties as capital gains rather than as 
ordinary income. Percentage depletion is not available in such cases. 

This provision cannot be used by taxpayers obtaining iron ore 
royalties from related individuals or corporations. Xo similar limita- 
tion applies to coal royalties. 

Impact 

The extent to which this provision results in tax saving depends on 
how the benefits compare with those from percentage depletion. In 
past years, percentage depletion on coal often has been large enough 
relative to profits to subject many firms to the "net income limitation'' 
which limits percentage depletion to 50 percent of net income. This 
apparently has not been the case for iron ore where !the percentage 
depletion deduction is less likely to be subject to the net income 
limitation. 

For corporations, a percentage depletion deduction equal to 50 
percent of net income reduces the effective tax rate to 24 percent (one- 
half of 48 percent) whereas the capital gains treatment results in a 
30 percent tax rate. However, if the mine has a high basis for calcu- 
lating cost depletion (which can be claimed ratably as an offset to 
capital gains), the election of this provision may result in a lower 
tax. Similarly, if the percentage depletion deduction is less than the 
net income limitation, capital gains treatment may be preferred. 

For individuals, the tax reduction from the capital gains deduction 
is equivalent to that for percentage depletion when the net income 
limitation is applicable — taxable income is reduced by 50 percent. If 
the net income limitation for percentage depletion does not apply, or 

(35) 



36 

if the individual elects the alternative capital gain rate, capital gains 
treatment will be more favorable. 

Note that in view of recently rising coal prices, the percentage 
depletion allowance will be less likely to reach the net income limita- 
tion and thus less likely to reduce tax rates by one-half. The value of 
newly purchased coal deposits also will be likely to rise — thus in- 
creasing the value of cost depletion. As a consequence, capital gains 
treatment which reduces tax rates by one-half for individuals may 
become relatively more valuable than percentage depletion for a 
larger number of individuals. 1 

Rationale 

Capital gains treatment for coal royalties was adopted in the Reve 
nue Act of 1951. The legislative history suggests it was adopted to 
(1) extend the same treatment to coal lessors as that allowed to timbe 
lessors (see p. 37), (2) provide benefits to long-term lessors with low 
royalty rates who were unlikely to benefit significantly from the 
percentage depletion deduction, and (3) to encourage the leasing and 
production of coal. 

Capital gains treatment of iron ore ro} T alties was added in the 
Revenue Act of 1964 to make the treatment of iron ore generally 
consistent with coal, and to encourage leasing and production of 
iron ore deposits in response to foreign competition. 

Selected Bibliography 

Agria, Susan. "Special Tax Treatment of Mineral Industries", 
in The Taxation of Income jrom Capital, Arnold C. Harberger and 
Martin J. Bailey, eds. Washington, D.C., The Brookings Institution, 
1969, pp. 77-122. 

U.S. Congress. House Committee on Ways and Means. General 
Tax Reform. Public Hearings. Testimony of E. V. Leisenring, National 
Coal Association, Part 5, March 19-20, 1973, pp. 2223-30. 



1 No estimated distribution of the individual tax expenditure by adjusted gross income class is provided 
because in 1975 when the distributions were prepared by the Treasury Department, there was so rela- 
tively little known usage of this provision by individuals that no distribution was prepared. 



TIMBER: CAPITAL GAINS TREATMENT OF 

CERTAIN INCOME 

Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


65 

60 
60 


165 
155 
145 


230 
215 
205 



Authorization 

Sections 631 (a) and (b), 1221 and 1231. 

Description 

If a taxpayer has held standing timber or the right to cut it for more 
than 6 months by the first day of the taxable year, the taxpayer may 
elect to treat the cutting of this timber as the sale of a long-term 
capital asset at a price equal to its fair market value on the first day 
of the taxable year. Therefore, if an election is made, gain realized up 
to the first of the year on the cut timber is capital gain. Changes in the 
value of the timber after the first of the year as it is processed or manu- 
factured will result in ordinaiy income or loss, and not capital gain or 
loss. Capital gain treatment also can apply to the sale of a stand of 
timber and the sale of timber as it is cut by the buyer. Timber includes 
ornamental evergreens which are 6 years of age when severed from the 
roots. 

Some of a timber owner's costs which maintain or even arguably 
improve his trees, such as disease control and thinning costs, can be 
expensed currently (see Appendix A), even though their effects may 
continue beyond the year in which they are made, and though they 
are related to income which only will be recognized many years in the 
future. Therefore, timber ownership offers opportunities for some tax- 
payers to deduct current expenses associated with such ownership 
against ordinary income from other sources. 

Impact 

The capital gains treatment of the cutting and sale of timber 
constitutes a departure from the general rule that sale of a taxpayer's 
inventory yields ordinary income. However, when timber is inventory, 
it is usually held substantially longer than other types of inventory. 

Both individual and corporate taxpayers are eligible for this treat- 
ment. The graduated structure of the individual income tax rates 

(37) 



38 

makes the provision more beneficial to individuals with high incomes 
because the value of the deduction for capital gains increases with the 
marginal income tax rate. 

Two industries — paper and allied products and lumber and wood 
products — claim disproprotionately large amounts of corporate capital 
gains. According to 1972 Preliminary Statistics of Income for Corpora- 
tions, 24 percent of taxable income of paper and allied products in- 
dustries and 42 percent of taxable income of lumber and wood prod- 
ucts were long-term capital gains. Tins proportion may be contrasted 
with a proportion of 4.4 percent for all other corporations. These two 
industries reported 16.9 percent of all corporate capital gains while 
accounting for only 2.7 percent of taxable income. Treasury Depart- 
ment studies published in 1969 indicate that in these industries there 
were five corporations which account for about one-half of the capital 
gains claimed, 16 firms account for about two-thirds, and 80 percent 
of the gains are accounted for by approximately 60 corporations. 



Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 1 

... , . , , , - , „ N Percentage 

Adjusted gross income class (thousands of dollars): distribution 

0to7 7.3 

7 to 15 12.7 

15 to 50 23.6 

50 and over 56. 4 

i The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting 
from these tax provisions is not reflected in this distribution table. 

Rationale 

The sale of a timber stand that had not been held in the course of 
business was long considered the sale of a capital asset. The Revenue 
Act of 1943 extended this capital gain treatment to all persons who 
cut and sell their timber and to those who lease timber stands for 
cutting. One reason for adopting this provision was to equalize treat- 
ment between the taxpayer who sold timber as a stand outright, and 
the taxpayer who cut timber for use in his business. It was also sug- 
gested that this treatment would encourage conservation of timber 
through selective cutting and that taxing the capital gain at ordinary 
rates was an unfair practice because of the comparatively long de- 
velopment time of timber. 

Selected Bibliography 

Briggs, Charles W. and Condrell, William K., Tax Treatment of 
Timber, 5th ed., Forest Industries Committee on Timber Valuation 
and Taxation, Washington, D.C. 1969. 

Sunley, Emil M., Jr., The Federal Tax Subsidy of the Timber 
Industry, U.S. Congress, Joint Economic Committee, The Economics 
of Federal Stibsidy Programs, Part 3 — Tax Subsidies, July 15, 1972, 
pp. 317-42. 

U.S. Congress Joint Publication of the Committee on Ways and 
Means and the Committee on Finance. Tax Reform Studies and 
Proposals. U.S. Treasury Department. Part 3, February 3, 1969, 
pp. 434-38. 



POLLUTION CONTROL: 5- YEAR AMORTIZATION 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 




15 
20 
30 


15 
20 
30 



Authorization 

Section 169. 

Description 

In lieu of depreciation, pollution control facilities that have been 
certified by both State and Federal agencies may be amortized over 
a 5-year period using the straight line method (i.e., 20 percent of the 
cost may be deducted each year). This rapid amortization is currently 
available only with respect to treatment facilities placed in service 
before 1976. Certification requires that the new facility be: (1) in- 
stalled in connection with a polluting facility ; (2) designed specifically 
for pollution abatement and not for any other purposes; (3) in com- 
pliance with both the Federal Water Pollution Control Act and the 
Clean Air Act; and (4) a new structure. The provision applies only 
to tangible abatement facilities installed in connection with polluting 
facilities in operation before 1969. 

Taxpayers may not claim an investment tax credit for property 
amortized under this provision. 

Impact 

The amortization provision has been used much less than it would 
otherwise have been because the investment tax credit cannot be 
used with amortized property. With the recent temporary increase 
of the investment tax credit to 10 percent (for 1975 and 1976) and the 
shortening of depreciation lives in 1971, the combined benefit of the 
credit and accelerated depreciation is usually greater than the bene- 
fit of rapid amortization. However, to the extent it is used, 5-year 
amortization for assets with longer useful lives benefits the taxpayer 
by effectively deferring current tax liability (see Appendix A). 

Kather than functioning as an incentive, the 5-year amortization 
of pollution control facilities subsidizes corporations that must 
comply with Federal or State law regarding pollution. State pollution 

(39) 



40 

regulations vary, and there are regional cost differences for a given 
facility; both may account for geographical differences in the usage 
of the subsidy. 

Rationale 

Section 169 was introduced for a 5-year period to ease the financial 
burden of complying with environmental regulations when the Tax 
Reform Act of 1969 repealed the investment tax credit. When the 
investment tax credit was reinstated in 1971, rapid amortization 
was retained as an option. 

Further Comment 

Congress, in 1974, extended the availability of the amortization 
election for an additional year until December 31, 1975. Although 
the extension recently has expired, it still will have a revenue impact 
for all years in which property is amortized under its provisions. The 
provision may be reinstated retroactively. 

Selected Bibliography 

Moore, Michael L. and G. Fred Streuling, "Pollution Control 
Devices: Rapid Amortization Versus the Investment Tax Credit," 
Taxes, January 1974, pp. 25-30. 

McDaniel, Paul R. and Alan S. Kaplinsky, "The Use of the Federal 
Income Tax to Combat Air and Water Pollution," Boston College 
Industrial and Commercial Law Review, February 1971, pp. 351-86. 



CORPORATE SURTAX EXEMPTION 

Estimated Revenue Loss 

[In millions of dollars] 
Fiscal year Individuals Corporations Total 



1977 6,185 6,185 

1976 5,015 5,015 

1975 3,345 3,345 



Section 11. 



Authorization 



Description 



The permanent corporate income tax consists of a normal tax rate 
of 22 percent and a surtax of 26 percent for a total tax rate of 48 per- 
cent. The first $25,000 of profits are exempted from the surtax. 

Temporary provisions in the Tax Reduction Act of 1975 and the 
Revenue Adjustment Act of 1975 reduce the normal tax rate to 20 
percent on the first $25,000 of profits and 22 percent on the next 
$25,000 of profits, thus raising the exemption from the surtax to $50,000. 
These changes are presently in effect only through June 30, 1976. 

Impact 

The surtax exemption is available to all corporations. It tends to 
neutralize the tax differential between a business operating as a sole 
proprietorship or a partnership and a corporation by lowering the 
corporate tax rate on the first $25,000 ($50,000 in 1975 and part of 
1976) to rates comparable to the individual rates. The exemption 
encourages the use of the corporate structure and allows some small 
corporate businesses that might otherwise operate as sole proprietorships 
or partnerships to provide fringe benefits. It also encourages the 
splitting of operations between sole proprietorships, partnerships and 
corporations. Most businesses are not incorporated; only about 5 
percent of all businesses are affected by this provision, and not all 
of those receive the full tax benefit because their taxable income is 
less than $25,000 ($50,000 in 1975 and part of 1976). 

Rationale 

Since almost the earliest days of the corporate income tax, some 
level of profits has been exempted from the full corporate tax rate. 
The split between a normal tax and a surtax was not, however, fully 
accomplished until the Revenue Act of 1941. The surtax exemption 

(41) 



42 

in its present form was adopted as part of the 1950 Revenue Act. 
The purpose was to provide relief for small businesses. However, many 
large businesses fragmented their operations into numerous corpora- 
tions to obtain numerous exemptions from the surtax. Some remedial 
steps were taken in 1963; in 1969, legislation was enacted limiting 
groups of corporations controlled by the same interest to a single surtax 
exemption. 

Selected Bibliography 

Capital Formation. Prepared for the use of the Committee on Ways 
and Means by the Staff of the Joint Committee on Internal Revenue 
Taxation, October 2, 1975. 

Pechman, Joseph. Federal Tax Policy. Rev. ed. Washington, D.C. : 
The Brookings Institution, 1971, pp. 131-33. 



DEFERRAL OF TAX ON SHIPPING COMPANIES 



Estimated Revenue Loss 





[In millions of dollars] 




Fiscal j'ear 


Individuals Corporations 


Total 


1977 

1976 

1975 


130 

105 

70 


130 

105 

70 




Authorization 





46 U.S.C. Section 1177 (§ 607 of the Merchant Marine Act of 1936 
as amended). 

Description 

United States operators of vessels operating in foreign, Great Lakes, 
or noncontiguous domestic trade or in the U.S. fisheries may establish 
a capital construction fund (CCF) in which they may deposit income 
earned by the vessels. Such deposits are deductible from taxable 
income, and income tax on earnings of deposits in the CCF is deferred. 

When such tax-deferred deposits and their earnings are withdrawn 
from a CCF, no tax is paid if the withdrawal is used for qualifying pur- 
poses, such as to construct or acquire a new vessel or to pay off the 
indebtedness on a qualifying vessel. The tax basis of the vessel (usually 
its cost to the taxpayer) on which the operator's depreciation is com- 
puted is reduced by the amount of such withdrawal. Thus, over the life 
of the vessel, tax depreciation will be reduced and taxable income will 
be increased by the amount of such withdrawal, thereby reversing the 
effect of the deposit. However, since gain on the sale of the vessel and 
income from the operation of the replacement vessel may also be de- 
posited into the CCF, the tax deferral may be extended indefinitely. 

Only withdrawals for purposes other than for construction, acquisi- 
tion, or payment on indebtedness of a qualifying vessel are taxed at 
the time of withdrawal, subject to an interest charge for the period dur- 
ing which tax was deferred. 

Impact 

Since 1970, over $550 million has been deposited into CCFs by 96 
carriers, and almost $250 million has been withdrawn. 

Rationale 

The provision is designed to stimulate American shipbuilding and to 
recapture some of the foreign yard construction now being done for 
U.S. companies. 

(43) 



44 

Further Comment 

An important unresolved issue is whether the investment tax 
credit should be extended to vessels constructed with funds withdrawn 
from CCFs. Currently, it does not. However, a provision of the 
Maritime Appropriation Authorization Act of 1975, as adopted by 
the Senate but dropped in Conference, would have allowed the credit 
on such vessels. 

Selected Bibliography 

Jantscher, Gerald R. Bread Upon the Waters. — Federal Aid to the 
Maritime Industries, The Brookings Institution — Washington, D.C., 
1975, 164 pages. 



RAILROAD ROLLING STOCK: 5-YEAR 
AMORTIZATION 



Estimated Revenue Loss 



[In millions of dollars] 




Fiscal year Individuals Corporations 


Total 


1977 10 

1976 30 

1975 55 


10 
30 
55 


Authorization 

Section 184. 

Description 





Instead of being depreciated on an accelerated basis over its normal 
useful life, qualified railroad rolling stock placed in service after 1968 
and before 1976 may be amortized over a 5-year period using the 
straight line method. The use of five-year amortization for assets 
whose useful lives are longer benefits the taxpayer by effectively 
deferring current tax liability (see Appendix A). The investment tax 
credit is not available for property subject to this rapid amortization. 

Impact 

Since this tax incentive was adopted to increase the supply of rail- 
road rolling stock, there has been a decline in both total dollar amount 
of railroad rolling stock purchases and use of the 5-year amortization 
provision. The decreasing use can be explained largely by the rein- 
statement of the investment tax credit in 1971, which is generally 
more advantageous than rapid amortization. 

There are 67 Class I railroads in the United States. Since 1972, 27 
of them have used the amortization provision. 

Only railroad companies with taxable income benefit directly from 
the rapid amortization provision. Railroad companies without taxable 
income, in effect, sell their right to this rapid amortization to financial 
companies who initially acquire the rolling stock and then lease it to 
the railroads. As a result, some of the tax benefits from this provision 
accrue to lessors that are not railroad companies. 

Rationale 

Section 184 was adopted as part of the Tax Reform Act of 1969 when 
the investment tax credit was repealed. The purpose was to encourage 
the modernization of railroad equipment, increase railroad efficiency, 

(45) 



46 

reduce freight car shortages during seasonal peaks, and aid the 
financing of new equipment acquisitions. Although it expired Decem- 
ber 31, 1975, a retroactive reinstatement may occur in 1976. 

Selected Bibliography 

Benevenutto II, Frank A., "Lease Rolling Stock and Enjoy Con- 
siderable Benefits", Taxes, September 1973, pp. 530-36. 



BAD DEBT DEDUCTIONS OF FINANCIAL 
INSTITUTIONS IN EXCESS OF ACTUAL LOSSES 



Estimated Revenue Loss 



[In millions of dollars] 




Fiscal year Individuals Corporations 


Total 


1977 570 

1976 815 

1975 880 


570 
815 

880 



Authorization 

Sections 585, 593, and 596; Revenue Rulings 65-92 (C.B. 1965-1, 
112), 68-630 (C.B. 1968-2, 84). 

Description 

In general, businesses are permitted to deduct as a current operating 
expense a reasonable allowance for bad debts. The allowance usually 
is based on the experience of prior years. However, the special formulae 
used by financial institutions to compute bad debt reserves permits 
deductions in excess of actual experience. 

Prior to 1969, commercial banks were permitted a bad debt deduc- 
tion of 2.4 percent of outstanding loans. The 1969 Tax Reform Act 
reduced this figure to 1.8 percent for years through 1975, 1.2 percent 
from 1976-81, and .6 percent from 1982 through 1987. After 1987, 
commercial banks will be limited in their loss reserve deductions to 
actual recent loss experience. 

As an alternative to this treatment available for commercial banks, 
mutual savings banks and savings and loan associations have an 
option, under certain circumstances, to deduct a specified percentage 
of their taxable income. Under the provisions of the Tax Reform Act 
of 1969, this percentage-of -net-income allowance is being reduced 
from 60 to 40 percent by 1979. (The allowance for 1976 is 43 percent 
of taxable income.) Thereafter, the percentage allowance will remain 
at 40 percent. The total bad debt reserve of thrift institutions may 
may not exceed 6 percent of qualifying real property loans, or 
the percentage-of -net-income bed debt deduction will be disallowed. 
In addition, the annual bad debt deduction under this latter method 
will be reduced if the thrift institution's investments do not comprise 
specified proportions of certain ''qualified" assets, which for ''thrifts" 
are essentially residential mortgage-. 

(47) 



48 

Impact 

Bad debt reserve deductions in excess of actual experience lower the 
effective tax rates of financial institutions, particularly thrift in- 
stitutions, below the normal corporate tax rate of 48 percent. Apart 
from any other means of reducing tax liability, the 60 percent bad 
debt allowance resulted in a maximum effective tax rate for a thrift 
institution prior to the 1969 Tax Reform Act of 19.2 percent. 1 With 
full phase-in of the bad debt provisions of the 1969 Tax Act, the maxi- 
mum effective tax rate of a thrift institution qualifying for the full 
bad debt allowance will be 28.8 percent. 2 Therefore, to the extent the 
bad debt deduction induced thrift institutions to hold qualified 
assets, such as residential mortgages, before 1969, the provisions of 
the 1969 Tax Act have reduced the incentive effect of this tax 
expenditure. 

Rationale 

The tax treatment of commercial banks evolved separately from 
that of thrift institutions. The allowance for special bad debt reserves 
of commercial banks was first provided by IRS ruling in 1947, when 
there was fear of a postwar economic downturn. It was intended to 
reflect the banking industry's experience during the depression 
period. 

The special treatment of bad debt reserves for thrift institutions 
was added by statute in 1951. Prior to that time, savings and loan 
associations and mutual savings banks were exempt from taxation, 
in most instances because they were viewed as mutual organizations 
rather than corporations. Upon removal of this tax exempt status, 
special, and very favorable, treatment of bad debt reserves was 
provided for savings and loan institutions and mutual savings banks, 
which in effect left them virtually tax-exempt for a number of years 
thereafter. Some of the same factors which led to their tax exemption 
probably account for the special allowance for bad debts, especially 
in that these institutions are thought to fill an important role in 
providing home mortgage funds. 

Selected Bibliography 

U.S. Congress. Joint Publications of the Committee on Ways and 
Means and the Committee on Finance, Tax Bejorm Studies and Pro- 
posals, U.S. Treasury Department, Part 3; Chapter 1X-D, Tax 
Treatment of Financial Institutions, pp. 458-75. 

U.S. Treasury Department, Report on the Financial Institutions 
Act of 1973, A Section-by -Section Analysis, Department of the 
Treasury News, October 11, 1973. 

i.48-.6(.48) = .192. 

2 .48— .4(. 48) =.288 (without taking the minimum tax into account). 



DEDUCTIBILITY OF NONBUSINESS STATE 
GASOLINE TAXES 



Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


600 

575 

820 


600 
575 
820 



Authorization 

Section 164(a)(5). 

Description 

State and local sales taxes on gasoline, diesel fuel, and other major 
fuels are deductible even if the taxes are not trade or business expenses 
or expenses for the production of income. Federal fuel taxes are not 
so treated. 

Impact 

This deduction benefits only taxpayers who own motor vehicles 
and itemize deductions rather than take the standard deduction. 
These tend to be middle and higher income taxpayers. Gasoline 
prices are reduced for taxpayers who claim the deduction, and the 
amount of this tax benefit per dollar of deduction increases with the 
tax bracket of the taxpayer. 

State and local gasoline taxes are "user taxes'' in the sense that the 
revenues they generate are generally earmarked for road maintenance 
and other State and local services provided highway users. The de- 
duction allowed for these taxes is contrary to the general nondeduct- 
ible treatment of user taxes. Therefore, one effect of this deduction 
is to shift some of the burden of these user taxes to all Federal tax- 
payers, regardless of the extent to which they use these local road 
facilities. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

Oto 7 3.2 

7 to 15 32. 3 

15 to 50 60.3 

50 and over 4. 2 

(49) 



50 

Rationale 

Before 1964, a deduction for both business and nonbusiness State 
and local taxes was allowed in computing taxable income. The Rev- 
enue Act of 1964 eliminated the deduction for many taxes. The bill 
first passed by the Ways and Means Committee also eliminated the 
deduction for gasoline taxes, but the Senate Finance Committee 
restored it. It was retained by the Conference. The stated rationale 
for retention of the deduction was to prevent large shifts in the tax 
burden of individuals, to assist the States with fiscal coordination 
in a Federal system, and to allow the States free choice in their selec- 
tion of a tax structure. 

Selected Bibliography 

Goode, Richard. The Individual Income Tax, Rev. ed. The Brook- 
ings Institution, Washington, D.C., 1976, pp. 168-71. 

Davie, Bruce F. and Bruce F. Duncombe, "The Income Distri- 
bution Aspects of Energy Policies", Studies in Energy Tax Policy, 
Cambridge, Massachusetts, Ballinger Publishing Companv, 1975, 
pp. 343-72. 

Simplification of the Tax Return and Other Miscellaneous Sim- 
plification Items, Prepared for the use of the Committee on Ways and 
Means by the Joint Committee on Internal Revenue Taxation, 
October 2, 1975. 



DEPRECIATION ON RENTAL HOUSING IN EX- 
CESS OF STRAIGHT LINE, AND DEPRECIATION 
ON BUILDINGS (Other Than Rental Housing) IN 
EXCESS OF STRAIGHT LINE 



Estimated Revenue Loss 

[In millions of dollars] 



Depreciation on Depreciation on 

rental housing buildings 



Indi- Cor- Indi- Cor- 

Fiscal year vid- pora- Total vid- pora- Total 
uals tions uals tions 



1977 


_ 455 


125 


5S0 


215 


280 


495 


1976 


_ 430 


120 


550 


215 


275 


490 


1975 


_ 405 


115 


520 


220 


220 


440 



Authorization 

Section 167(b) and (j). 

Description 

Businesses are allowed to recover the cost^of their durable assets 
that wear out or become obsolete by deducting from gross income an 
allocable portion of the cost of the assets. Normally these depreciation 
deductions are spread over the useful life of the asset, and the total 
amount equals the asset's cost less salvage value. Taxpayers are 
generally offered the choice of using the straight line method (in which 
an equal amount of depreciation is deducted each year of the asset's 
life) or accelerated methods of depreciation (in which greater amounts 
are deducted in the early years). A taxpayer can switch from the de- 
clining balance or the sum of the years-digits methods of accelerated 
depreciation to straight line depreciation when it becomes advantage- 
ous to do so as the asset grows older. 

The use of accelerated depreciation on structures is limited as 
follows : 

Residential Rental Units 

(1) Xew construction may be depreciated under any method 
allowed by the Internal Revenue Code. 

(2) Used buildings having at least a 20-year life when acquired 
may be depreciated under the declining balance method using a 
rate not in excess of 125 percent of the straight line rate. 

Other Structures 

(1) Xew construction may be depreciated by any accelerated 
method which does not yield depreciation greater than the 
declining'balance method using a rate not exceeding 150 percent of 
the straight line rate. 

(51) 



52 

(2) Used buildings may be depreciated on the straight line 
method or any other reasonable method that is neither a declining 
balance or sum of the years digits method. 

Example 

Assume a used residential structure with a basis of $10,000, an 
expected remaining life of 25 years, and no salvage value. If the 
straight line method were used, the deduction would be $400 each 
year. Under accelerated depreciation, the first-year depreciation allow- 
ance can be computed as follows: 

Depreciation allowance=125%Xl/25X$10,000 = $500 

In the second year, the depreciation allowance is computed in the 
same way except the original basis of $10,000 is now reduced by 
the amount previously depreciated. Hence, the new basis equals 
$9,500. The second year computation is: 

Depreciation allowance=125%Xl/25X$9,500 = $475 

Thus, in each succeeding year, there is a decrease in the amount of 
depreciation claimed for tax purposes, and therefore an increase in 
tax liability compared to what it would be otherwise. 

Impact 

Because accelerated depreciation allows for larger deductions in 
the early years of the asset's life and smaller depreciation deductions 
in the later years, accelerated depreciation results in a deferral of 
tax liability. It is a tax expenditure to the extent it is faster than 
economic (i.e. actual) depreciation. It is widely believed to be con- 
sistent with actual experience to allow accelerated depreciation for 
some machinery and equipment which, in many cases, decline in value 
more rapidly in their early years than later years. However, similar 
treatment for buildings is generally believed inconsistent with their 
rates of economic decline in value which are generally much slower 
than those of machinery and equipment. 

The direct benefits of accelerated depreciation for structures 
accrue to owners of business buildings and rental housing. The benefit 
is estimated as the tax saving resulting from the depreciation deduc- 
tions in excess of straight line depreciation. About 77 percent of the 
tax saving from rental housing and 44 percent of the tax saving from 
nonresidential buildings accrue to individual owners. The remaining 
portion of each class of benefit goes to corporate owners. 

Efforts to repeal accelerated depreciation for real estate have been 
opposed on the ground that without this treatment, real estate invest- 
ments would be so unattractive relative to other forms of investment 
that drastic cut backs in building programs would result. On the 
other hand, it is argued that the tax benefits increase the production 
of new buildings only to the extent that demand for new buildings 
responds to small price changes, and that this response is relatively 
small. The impact of accelerated depreciation on rental housing is 
generally estimated to be greater than for nonresidential buildings 
since the demand for housing is more price elastic. 



53 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class* 

Depreciation on Rental HorsiNG 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

Oto 7 4.8 

7 to 15 16.8 

15 to 50 44. 3 

50 and over 34. 1 

Depreciation on Buildings 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

Oto 7 5. 

7 to 15 17.3 

15 to 50 44. 1 

50 and over 33. 6 

i The distribution refers to the individual tax expenditures only. The corporate tax expenditures result- 
ing from these tax provisions is not reflected in this distribution table. 

Rationale 

Prior to 1954, depreciation policy had developed through adminis- 
trative practices and rulings. The straight line method was favored 
by IRS and generally used. A ruling issued in 1946 authorized the use 
of the 150 percent declining balance method. Authorization for it and 
other accelerated depreciation methods first appeared in the statute in 
1954 when the double declining balance and other methods were 
authorized. The discussion at that time focused primarily on whether 
the value of machinery and equipment declined faster in their earlier 
years. However, when the accelerated methods were adopted, real 
property was included as well even though it did not decline more 
rapidly in value in its first years. By the 1960s, most commentators 
agreed that accelerated depreciation resulted in excessive allowances 
for buildings. In 1964, a provision was enacted which "recaptured" 
accelerated depreciation as ordinary income in varying amounts 
when a building was sold, depending on the length of time the property 
was held. However, recapture was not required for straight line de- 
preciation upon the transfer of real estate. In 1969, the current limi- 
tations were imposed and the "recapture" provision was slightly 
strengthened. 

Further Comment 

Several proposals have been made either to eliminate accelerated 
depreciation or to limit its benefits. One of the more generally ad- 
vocated changes would limit depreciation to the equity investment in 
the propert}^. Another would not allow real estate losses to offset 
income from other sources. There are many variations and combina- 
tions of these proposals (see for example H.R. 10612, 94th Cong., 
1st Sess.). 



54 

Selected Bibliography 

Surrey, Stanley S. Pathways to Tax Reform, Cambridge, Massa- 
chusetts, Harvard University Press, 1973. Chapter VII — Three Special 
Tax Expenditure Items: Support to State and Local Governments, to 
Philanthropy, and to Housing, pp. 209-46. 

Taubman, Paul and Robert Rasche. "Subsidies, Tax Law and 
Real Estate Investment". U.S. Congress, Joint Economic Committee. 
The Economics of Federal Subsidy Programs. Part 3. Tax Subsidies, 
July 15, 1972, pp. 343-69. 

U.S. Congress, House, Committee on Ways and Means, General 
Tax Reform, Panel Discussions, Part 4, "Tax Treatment of Real 
Estate", February 8, 1973, pp. 507-611. 

U.S. Congress, House, Committee on Ways and Means, Tax Reform. 
Hearings, Part 2, Panel Nos. 1 and 2, "Tax Shelters and Minimum 
Tax", July 16, 1975, pp. 1403-1607. 



EXPENSING OF RESEARCH AND 
DEVELOPMENT COSTS 



Estimated Revenue Loss 







[In millions of dollars] 






Fiscal year 


Individuals Corporations 


Total 




1977 

1976 

1975 


695 

660 

635 


695 
660 
635 


Section 174. 




Authorization 
Description 





Taxpayers may elect to deduct costs for research and development as 
incurred (i.e., these costs may be "expensed") even though such costs 
may be associated with income that is earned over several years. The 
cost then is deducted before the income it earns is realized. 

Impact 

The mismatching of costs and income operates, as accelerated 
depreciation does, to defer tax liability and thereby provide the tax- 
payer with an interest-free loan. 

For example, if Corporation Z expends $1,000 on an R&D program 
in a given taxable year, the entire sum is treated as a deduction from 
taxable income and represents a cash flow of $480 to the firm ($1,000 
X48 percent marginal tax rate = $480). The value of the current 
expense treatment, however, is the amount by which the present value 
of the immediate deduction exceeds the present value of periodic 
deductions taken over the useful life of the expenditure. 

The direct beneficiaries of this provision are firms which undertake 
research and development. Mainly, these are large manufacturing 
corporations. The scanty evidence available suggests that, of the total 
amount claimed as research and experimental costs, about 10 percent 
is basic research and 90 percent is product development. 

Expensing of research and development costs for tax purposes is 
consistent with the recent practice of a growing number of companies 
that expense these costs for financial accounting purposes. This 
treatment was approved by the Financial Accounting Standards 
Board in October 1974. 

(55) 



56 

Rationale 

This provision was added to the tax law in 1954. The general rule, 
then as now, was that the cost of assets that benefit future years must 
be capitalized and amortized over the assets' useful lives. Probably 
because there was difficulty in determining the useful life of such 
benefits, deduction was generally allowed. The treatment in a specific 
case was determined by the IRS administrative practice and court 
decisions. The purpose of the 1954 statute was to eliminate uncertainty 
in this area and to encourage expenditures for research and 
development. 

Selected Bibliography 

U.S. Congress, House, Committee on Ways and Means, Tax 
Revision Compendium, beginning Nov. 16, 1959, vol. 2, section G(4) — 
" Research and Development Expenditures," pp. 1105-23. 



INVESTMENT TAX CREDIT 



Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


. 1, 530 7, 585 

. 1, 410 6, 850 

950 4, 860 


9, 115 

8,260 
5,810 



Authorization 

Sections 38 and 46-50. 

Description 

The investment tax credit (ITC) is available to any taxpa}~er who 
invests in income-producing property which is eligible for the credit. 

Eligible investment is largely limited to tangible personal property, 
such as machinery and equipment, that is used in the United States. 
Most buildings are not eligible. 1 

The amount of the credit is subtracted from tax liability calculated 
without the credit. The credit is currently 10 percent of the qualified 
investment but will revert to 7 percent (4 percent for regulated util- 
ities) after December 31, 1976. The amount of investment that quali- 
fies for the credit is the full purchase price of property with a life of at 
least 7 years, two-thirds for property with a useful life of from 5 to 7 
3'ears, one-third for property with 3- to 5-}'ear life, and zero for 
property with a life of less than 3 3-ears. Only $100,000 of investment 
in used property ($50,000 after December 31, 1976) qualifies in any 
year. The maximum credit which can be claimed in any one } T ear is 
$25,000 plus 50 percent of tax liability over $25,000 (this rule is tem- 
porarily liberalized for regulated utilities). Any unused amount of the 
credit ma}' be carried back 3 years and carried over 7 years (for pre- 
1971 carryovers a 10-year period is allowed). Use of the credit does not 
reduce the cost of an asset for purposes of calculating depreciation. 

A corporate taxpayer may elect an additional 1 percent credit until 
December 31, 1976, if an amount equal to 1 percent of the qualified 
investment is contributed to an employee stock ownership plan. 

Impact 

The credit has two effects. First, it increases the recipient's cash 
flow. Second, it reduces the cost of capital and, therefore, can turn an 
unprofitable investment into a profitable one (or a profitable one into 

1 With certain exceptions, investments eligible for the credit include depreciable or amortizable property 
having a useful life of three years or more and include: (1) tangible personal property; (2) other tangible 
property (not including a building or its components) used as an integral part of (a) manufacturing, (b) ex- 
traction, (c) production, or (d) furnishing of transportation, communications, electrical energy, gas, water, or 
sewage disposal services; (3) elevators and escalators; and (4) research facilities and facilities for the bulk 
storage of fungible commodities. 

(57) 



58 

a more profitable one). Assume that an investor requires a 15 percent 
rate of return to undertake an investment project. A machine which 
costs $1,000 and provides an annual return of $135 does not meet the 
15 percent target. However, a 10 percent ITC reduces the net cost 
of the machine to $900, so the $135 annual return qualifies at the 15 
percent standard (15 percent of $900 = $135). 

While noncorporate businesses and individual investors benefit 
from the credit, 80 percent of the credit accrues to corporations. Since 
the credit is directly related to investment in durable equipment, much 
of the direct benefit is concentrated in manufacturing and utilities. 

According to 1972 tax data, 64 percent of the ITC is claimed by 
corporations with assets of $250 million or more. Two major industry 
categories account for 77 percent of the credit: manufacturing (44 
percent) and transportation, communication, electric, gas, and sani- 
tary services (33 percent). 

For some firms, e.g., public utilities, the credit on an investment may 
exceed the company's tax liability. Instead of purchasing the property, 
the firm may find it profitable to lease the equipment from a bank 
that is able to obtain full benefit from the credit. Securities and Ex- 
change Commission data indicate substantial use of the credit by 
banks through leasing arrangements. A refundable investment 
credit has been recommended by some persons for business firms that 
lose unused credits at the end of the carry-forward period. 

Several studies have produced little evidence that suggests the past 
changes in the application of the credit have been effective as short- 
run business cycle stabilization tools. Other studies have produced 
conflicting evidence as to the long-run effectiveness of the credit in 
stimulating investment which increases the rate of capital accumula- 
tion and economic growth. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 1 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

to 7 5. 1 

7 to 15 25. 

15 to 50 49.3 

50 and over 20. 5 

1 The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting 
from these tax provisions is not reflected in this distribution table. 

Rationale 

Originally adopted as part of the Revenue Act of 1962, the purpose 
of the credit was to stimulate investment and economic growth. The 
credit was also justified as a means of increasing the ability of American 
firms to compete abroad and of compensating for the effect of inflation 
on capital replacement. The credit was modified in 1964, suspended 
in September 1966, restored in March 1967, repealed in April 1969, 
reenacted in August 1971, and temporarily liberalized in March 
1975 until the end of 1976. 



59 

Selected Bibliography 

Brannon, Gerard M., "The Effects of Tax Incentives for Business 
Investment: A Survey of the Economic Evidence/' U.S. Congress, 
Joint Economic Committee, The Economics of Federal Subsidy Pro- 
grams, Part 3, Tax Subsidies, 92d Congress, 2d Session, July 15, 
1972, pp. 245 7 68. 

Tax Incentives and Capital Spending, Ga^ Fromm, ed., the Brook- 
ings Institution, Washington, D.C., 1971, 301 pages. 

U.S. Senate, Task Force on Tax Policy and Tax Expenditures 
and Task Force on Capital Needs and Monetary Policy, Committee 
on the Budget, Seminar — Encouraging Capital Formation Through 
The Tax Code, Committee Print, September 18-19, 1975. 

U.S. Congress, House, Committee on Ways and Means, General 
Tax Reform, Panel Discussions, 93d Congress, 1st Session, Part 3, 
Tax Treatment of Capital Eecovery, February 7, 1973, pp. 345-504. 

U.S. Library of Congress, "An Analysis of Tax Provisions Affecting 
Business Investment: Depreciation and the Investment Tax Credit" 
by Jane Gravelle, Congressional Research Service, Multilith 74-1 5 IE, 
August 14, 1975. 



67-312—76- 



ASSET DEPRECIATION RANGE 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


175 
155 
140 


1,630 
1,435 
1,270 


1, 805 
1,590 
1,410 



Authorization 

Section 167 (m); Regulation 1.167 (a)-ll; Rev. Proc. 72-10. 

Description 

The Internal Revenue Service has established useful lives for classes 
of depreciable assets. The asset depreciation range (ADR) system 
permits taxpayers to choose any useful life within a range of 20 percent 
more or less than the class life specified for a particular asset. If ADR 
is chosen, the taxpayer is not required to justify retirement and re- 
placement policies nor to show that they are consistent with the actual 
useful lives of their assets. 

Example 

Assume that a taxpayer has a $1,500 asset for which the class lifer 
established by the Internal Revenue Service is 10 years. Using double 
declining balance depreciation, without ADR, the deduction in the- 
first year would be 200 percentX.10X$l,500 = $300. After deduction 
of this depreciation charge, the adjusted basis of the asset is $1,200" 
($1,500— $300). In the second year, the deduction would be 200 per- 
cent X . 10 X $ 1 ,200 = $240. 

Under the asset depreciation range, a useful life of between 8 and 
12 years may be selected. If the taxpayer chose 8 years, the first year ~ 
deduction would be 200 percentX%X$l,500 = $375. In the second: 
year, the deduction would be 200 percentX%X$l,125 = $281.25.- 
Therefore, the use of ADR would result in additional deductions of $75* 
the first year ($375 — 300) and $41.25 the second year ($281.25 — 
240.00). 

Impact 

The ADR system, as accelerated depreciation (see Appendix A), 
reduces taxes early in the life of depreciable assets and thus increases 

(01) 



62 

cash flow during that time. The subsidy value of ADR is the tax saving 
from the allowance of a tax depreciation life shorter than the guideline 
life of the asset. Capital intensive businesses such as manufacturing 
firms and utilities are necessarily the most likely to take advantage ol 
ADR. 

Securities and Exchange Commission data indicate significant use 
of ADR by railroads, utilities, airline companies, and truck and 
equipment companies. Treasury Department data indicate that the 
use of ADR is more probable the larger the company, and the percent 
of investment covered by ADR increases with the asset size of the 
company. Sixty percent of all business fixed investment is covered by 
ADR, but about 80 percent of the business fixed investment of the 
360 largest corporations is covered. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 1 

Percentage 

Adjusted gross income class (thousands of dollars) : distribution 

to 7 4. 8 

7to 15 18. 1 

15 to 50 43.8 

50 and over 33. 3 

1 The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting 
from these tax provisions is not reflected in this distribution table. 

Rationale 

The ADR system was established in 1971 principally to stimulate 
investment and economic growth by deferring taxes through the ac- 
celeration of depreciation deductions. In addition, it was asserted the 
system would simplify the administration of the existing depreciation 
rules. 

Selected Bibliography 

Brannon, Gerard M. "The Effects of Tax Incentives for Business 
Investment: A Survey of the Economic Evidence." In U.S. Congress. 
Joint Economic Committee, The Economics of Federal Subsidy Pro- 
grams, Part 3, Tax Subsidies, 92d Congress, 2d Session, July 15, 1972, 
pp. 245-68. 

U.S. Congress. House Committee on Ways and Means, General 
Tax Beform. Panel Discussions. 93rd Congress, 1st Session. Part 3 — 
Tax Treatment of Capital Recovery, February 7, 1973, pp. 345-504. 

U.S. Library of Congress. "An Analysis of Tax Provisions Affecting 
Business Investment: Depreciation and the Investment Tax Credit" 
by Jane Gravelle. Congressional Research Service, Multilith 74- 
151E. August 14, 1975, 50 pages. 



DIVIDEND EXCLUSION 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


350 
335 
315 




350 
335 
315 



Section 116. 



Authorization 



Description 



An individual may exclude up to $100 ($200 for a joint return) of 
dividends received from domestic corporations. 

Impact 

Although this provision benefits all taxpayers who receive dividend 
income and have tax liability, only a small percentage of total divi- 
dends is affected by the provision because of the dollar limitation.' 
The tax saving per dollar of exclusion increases with the taxpayer's 
marginal tax bracket. In the aggregate, the benefits tend to accrue 
to middle- and high-income taxpayers because they are more likely 
to own stock. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

0to7 6.9 

7 to 15 21. 3 

15 to 50 56.3 

50 and over 15. 6 

Rationale 

_ In 1954 a dividend exclusion of $50 and a credit of 4 percent of 
dividends above that amount were adopted. The stated purpose was 
to provide partial relief from the "double taxation'' of dividends (the 
corporate income tax and the individual income tax on dividends) 
which, it was argued, hampered the ability of companies to raise 
capital. The exclusion was stated to be designed to afford greater relief 
for the low-income investor. 

(63) 



64 

In 1964, although the Administration recommended repeal of both 
the credit and exclusion, the credit was repealed and the exclusion 
was doubled. The reasons offered were (1) that the provisions had not 
achieved their objectives, (2) the change would remove the discrimina- 
tion in favor of high income taxpayers, (3) the change would en- 
courage broader ownership of stock, and (4) the change would raise 
revenues that could be used to reduce the individual taxes in general. 

Further Comment 

As indicated above the issue that gave rise to the initial enactment 
of the exclusion and credit is the "double taxation" of dividends or, 
more generally, the burden of taxes on capital and on corporate equity 
capital in particular. While the exclusion survives, it does relatively 
little to resolve this problem because of the low dollar ceiling. Many 
proposals for partial and full integration of the corporate and in- 
dividual income taxes have been made; some are cited in the selected 
bibliography. 

Selected Bibliography 

Goode, Richard. The Individual Income Tax, Rev. ed., the Brook- 
ings Institution, Washington, D.C., 1976, pp. 138-9. 

The Taxation of Income from Corporate Shareholding, Symposium 
sponsored by the National Tax Association — Tax Institute of America 
and Fund for Public Policy Research, National Tax Journal, Septem- 
ber 1975. 

Richard and Peggy Musgrave, Public Finance in Theory and 
Practice, New York: McGraw-Hill Book Co., 1973, pp. 267-297. 



CAPITAL GAINS: INDIVIDUAL (Other Than 
Farming and Timber) 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal 


year 


Individuals 


Corporations 


Total 


1977__ 
1976__ 




6, 

. 5, 
5, 


225 
455 
090 




6, 

• r >, 
5, 


225 

455 


1975__ 




090 









Authorization 

Sections 1201-1253. 

Description 

Gains on the sale of capital assets held for more than six months 
are subject to preferentially lower tax rates (see Appendix B). Also, 
gain on the sale of property used in a trade or business is treated as 
long term capital gain if all gains for the year on such property exceed 
all losses for the year on such property. Qualifying property used in a 
trade or business generally is depreciable property or real estate winch 
is held more than six months, but not inventory. 

Only one-half of long-term capital gains are included in income; 
or alternatively, on the first $50,000 of capital gain, the taxpayer 
may elect to pay a tax of 25 percent. 

Impact 

The deduction from gross income of half of capital gains results in 
tax rates half the normal rates. The alternative (25 percent) tax 
benefits only those individuals whose marginal tax rate is above 50 
percent. The tax treatment of capital gains increases the after-tax 
earnings on assets and thereby may encourage people to invest in 
assets which may appreciate in value. Furthermore, the tax preference 
may reduce the inhibiting effects of taxation on the sale of assets. 

The benefits of this provision are concentrated among high income 
individuals, with approximately two-thirds of the benefit received by 
those with adjusted gross incomes of $50,000 or more. The tax saving, 
per dollar of capital gain, increases with the tax bracket of the tax- 
payer. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Adjusted gross income class (thousands of dollars) : distribution 

to 7 3. 1 

7 to 15 7. 5 

15 to 50 23. 1 

50 and over _ 66. 3 

(65) 



66 

Rationale 

Although the original 1913 law taxed capital gains at ordinary 
rates, the 1921 law provided for an alternative flat rate tax of 12.5 
percent. The intent of this treatment was to minimize the influence 
of the high progressive rates on market transactions. The Committee 
Report noted that these gains are earned over a period of years but 
are nevertheless taxed as a lump sum. Over the years many revisions 
in this treatment have been made including the temporary adoption 
of a sliding scale treatment (where lower rates applied the longer 
the asset was held). The current approach was adopted in 1942 and 
has remained in that form with minor revisions. 

Further Comment 

Many reasons have been advanced for preferential treatment of 
capital gains income with the major ones being: (1) capital gains are 
accrued over a long period of time and should not be subject to tax 
under progressive rates as a lump sum, (2) capital gains reflect infla- 
tion to a substantial extent and are thus not real income, and (3) 
because an asset owner has discretion as to when to realize gains, the 
existence of ordinary tax acts as a barrier to transactions in the 
capital market and leads to "lock-in" effects (asset owners refrain 
from selling because of the tax) with attendant distorting effects on 
savings, investment, and economic efficiency. 

On the other hand, arguments have been advanced against the 
preferential treatment of capital gains: (1) even if capital gains were 
taxed as ordinary income, the advantage remains of the deferral of 
tax on unrealized gains, (2) inflation affects returns on assets in 
general, not just capital gains transactions, and assists asset purchases 
made with borrowed funds, (3) the "lock-in" problem might be dealt 
with in other ways, such as taxing gains transferred at death (thus 
removing the opportunity to avoid capital gains taxes entirely), and 
(4) the "bunching" problem can be met by a special averaging 
provision. 

Selected Bibliography 

Bailey, Martin J., "Capital Gains and Income Taxation," in The 
Taxation of Income from Capital, The Brookings Institution, Washing- 
ton, D.C., pp. 11-49. 

David, Martin. Alternative Approaches to Capital Gains Taxation, 
The Brookings Institution, Washington, D.C., 1968. 

Martin, David and Roger Miller, "The Lifetime Distribution of 
Realized Capital Gains," U.S. Congress, Joint Economic Committee, 
The Economics oj Federal Subsidy Programs, Part 3 — Tax Subsidies, 
July 15, 1972, pp. 269-85. 

U.S. Congress, House Committee on Ways and Means, Panel 
Discussions. General Tax Reform, Part 2 — Capital Gains and Losses, 
February 6, 1973, pp. 245-341. 






CAPITAL GAINS TREATMENT: CORPORATE 
(Other Than Farming and Timber) 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 





900 
760 
695 


900 
760 
695 



Authorization 

Sections 1201, 1231, 1245, 1250, and miscellaneous others. 

Description 

Two main types of long-term capital gains are realized by cor- 
porations — the sale of a capital asset held for more than 6 months 
and, if gains for the year exceed losses for the year, the sale of property 
used in a trade or business for more than 6 months. (See Appendix B.) 
Most corporate capital gain is of the latter kind. 

Long term capital gains realized by corporations generally require 
a dual tax computation. They are first included in income, and a tax 
on the total income, including the capital gain, is computed using the 
regular rates. In the "alternative" computation, a tax on all income 
other than long-term capital gain is computed at regular rates. The 
long term capital gain is taxed at a 30 percent rate, and the two result- 
ing taxes are added together to yield the ''alternative" tax. The lower 
of the tax computed the regular way or the ''alternative" tax is the 
tax liability. Thus, a corporation must include the full amount of net 
long-term capital gains in taxable income but may apply the special 
30 percent alternative capital gain tax rate on the gain. 

Regular tax rates for corporations are 22 percent on the first 825,000 
and 48 percent on any taxable income over 825,000. (Temporary pro- 
visions allow a 20-percent rate on the first $25,000, 22 percent on the 
next 825,000, and 48 percent on amounts over $50,000. These pro- 
visions will expire on June 30, 1976 unless renewed.) 

Corporations are allowed to offset capital losses only against capital 
gains. Any remaining capital losses may be carried back for 3 years 
and forward for 5 years. Gain on most depreciable tangible personal 
property used in a trade or business will be treated as ordinary income 
to the extent it arises from depreciation that has been allowed after 
1961, i.e., the depreciation is recaptured; but only a small part of 
depreciation on real estate is ' 'recaptured." 

(67) 



68 

Example 

To illustrate, assume a corporation has, for the taxable year 1975, 
taxable income of $250,000, which includes net long-term capital 
gains of $60,000. 

Tax Computed in Regular Manner: 

Taxable income _ _ $250, 000 

Tax* 

(20 percent X $25,000) 5, 000 

(22 percent X $25,000) 5, 500 

(48 percent X $200,000) 96, 000 

Total 106,500 

Partial tax' on $190,000 ($250,000-60,000): 

(20 percent X $25,000) 5, 000 

(22 percent X $25,000) 5, 500 

(48 percent X $140,000) 67, 200 

30 percent of $60,000 18, 000 

Alternative tax 95, 700 

The alternative tax is $10,800 less than the regular tax, and in this 
example, the tax expenditure is the tax savings attributable to the 
alternative tax computation. 

Impact 

Corporations with taxable income over the surtax exemption that 
realize income from the sale of long-term capital assets are the direct 
beneficiaries of this provision. Corporations that make use of the al- 
ternative tax reduce their tax liability and consequently increase their 
cash flow. 

According to 1972 tax return data, capital gains taxed at alternative 
rates averaged 5 percent of taxable income for all corporations. For the 
following industries (excluding farming and timber) the percentage 
was higher than the average: metal mining; primary metals industries; 
banks; holding and investment companies; and real estate. Finance, 
insurance, and real estate combined claimed 30 percent of all corporate 
capital gains taxed at alternative rates. 

Rationale 

The Kevenue Act of 1942 introduced the alternative tax for cor- 
porations at a 25-percent rate, the alternative tax rate for individuals. 
This tax relief was premised on the belief that many wartime sales 
were involuntary conversions which could not be replaced during 
wartime and that resulting gains should not be taxed at the greatly 
escalated wartime rates. The Tax Reform Act of 1969 increased the 
alternative rate to 30 percent. The adoption of this revision was based 
on several considerations, including the adoption of the limitation of 
the alternative capital gains tax for individuals to the first $50,000 
of capital gains and the absence of the "bunching" problem (i.e., 
income earned over several years is recognized in a single year) that 
arises mostly in the individual tax because of graduated rate* 



•.->. 



69 

Further Comment 

The effect of the difference in tax rates on ordinary income versus 
capital gains is not the same for corporations as for individuals for a 
number of reasons. Much of the capital gain results from sales in the 
normal course of business for a corporation. Further, the ability to 
exemot gains from tax by death transfers is not available. Finally, 
there is little ' 'bunching" problem since the corporate rate is generally 
not a graduated rate. 

Selected Bibliography 

David, Martin. Alternative Approaches to Capital Gains Taxation, 
The Brookings Institution, Washington, D.C., 1968, 280 pages. 

U.S. Congress, House Committee on Ways and Means, "Tax 
Treatment of Capital Gains/' Tax Revision Compendium. Prepared 
for the House Committee on Ways and Means by Dan Throop Smith, 
1959, Washington, D.C.: Government Printing Office, pp. 1233-124U 



EXCLUSION OF CAPITAL GAINS AT DEATH 



Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


. 7,280 

. 6,720 

. 6,450 


7,280 
6,720 
6,450 



Authorization 

Sections 1001, 1002, 1014, 1221, and 1222. 

Description 

A capital gains tax generally is imposed on the increased value of a 
capital asset when the asset is sold, transferred, or exchanged. This 
tax, however, is not imposed on the appreciated value of such property 
if it is transferred as a result of the death of the owner; and any sale 
by the transferee is taxable only to the extent of appreciation subse- 
quent to the transferor's death (or six months after death if the 
alternative valuation for estate tax is elected). Thus, appreciation 
during the decedent's life is not subject to the income tax. 

However, the assets are subject to the Federal estate tax based 
upon their value at the time of death. 

Impact 

The exclusion of capital gains at death is most advantageous to 
individuals who need not dispose of their assets to achieve financial 
liquidity. Generally speaking, these tend to be wealthier investors. 
The deferral of tax on the appreciation involved combined with the 
exemption for the appreciation before death is a significant benefit 
for these investors and their heirs. 

Failure to tax capital gains at death encourages "lock-in" of assets 
which in turn means less turnover of funds available for investment. 
Certain revisions in the portfolio of an investor might result in more 
profitable before- tax rates of return, but might not be undertaken if 
the resulting capital gain tax would reduce the ultimate size of the 
estate. The investor may, therefore, choose to retain his assets until 
his death, at which time portfolio revisions can be made by executors 
without incurring a capital gains tax liability. Taxpayers are said to be 
"locked into" such investments. 

(71) 



72 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

to 7 6. 3 

7 to 15 15. 1 

15 to 50 36. 9 

50 and over 41. 7 

Rationale 

The rationale for this exclusion is not indicated in the legislative 
history of any of the several interrelated applicable provisions. How- 
ever, one current justification given for the exclusion is that death is 
considered as an inappropriate event to result in the recognition 
of income. 

Further Comment 

Taxation of capital gains at death could cause liquidity problems 
for some taxpayers such as owners of small farms and businesses. 
Most proposals for taxing capital gains at death would combine 
substantial averaging provisions, deferred tax payment schedules, 
and a substantial deductible floor in determining the amount of the 
gain to be taxed. Another approach would require that the decedent's 
tax basis be carried over to the heirs who would be taxed on apprecia- 
tion if they sell the property. This solution continues the deferral and 
lock-in effect discussed above. 

Selected Bibliography 

Break, George F. and Pechman, Joseph A. Federal Tax "Rejorm: 
The Impossible Dream, The Brookings Institution, Washington, D.C. 
1975, pp. 47-8. 

Pechman, Joseph A. Federal Tax Policy, Rev. ed., the Brookings 
Institution, Washington, D.C, 1971, p. 97. 

U.S. Congress, House, Committee on Ways and Means, General 
Tax Reform, Panel Discussions, Part 10 — Estate and Gift Tax Re- 
vision, February 27, 1973, pp. 1487-1668. 



DEFERRAL OF CAPITAL GAINS ON HOME SALES 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal 


year 


Individuals 


Corporations 


Total 


1977_. 

1976__ 
1975__ 




. 890 

845 

. 805 




890 
845 
805 









Authorization 

Section 1034. 

Description 

Gain from selling a residence is not taxed if the taxpayer purchases 
another residence with a cost at least equal to the sale price of the old 
residence within 18 months before or after the sale of the old residence. 
This treatment also applies if the seller constructs a new home of equal 
or greater value if construction begins within 18 months of the sale 
and if the taxpayer occupies the new residence within 2 years of the 
sale. 

If the new residence costs less than the sale price of the old, the 
difference in price is subject to tax. 

The tax basis of the new residence is reduced by the amount of the 
untaxed gain on the sale of the old residence. Therefore, the gain on 
the sale of the first home will be recognized, if at all, at the time of the 
sale of the second home. However, the tax may again be deferred on 
the gain from the sale of both homes if another home is purchased by 
a taxpa}'er meeting the requirements of section 1034. The interaction 
of section 1034 and section 121 which benefits those over 65 (see p. 129) 
will result in ultimate exemption from tax of part or all of the pre- 
viously unrecognized gain if the taxpayer sells his second or subsequent 
home with a carryover basis after he is 65. 

Impact 

As with any tax deferral, the taxpayer receives the equivalent of an 
interest-free loan. This provision benefits primarily middle and upper 
income taxpavers (about four-fifths of the benefit accrues to those in 
the $7,000-850,000 adjusted gross income (AGI) class). This subsidy 
facilitates the ownership of increasingly expensive homes, much of 
the increase in which in many cases is attributable to inflation. 

(73) 



74 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Adjusted gross income class (thousands of dollars) : distribution 

to 7 6. 7 

7 to 15 23. 9 

15 to 50 50. 9 

50 and over 12. 5 

Rationale 

The provision was adopted in 1951 to relieve financial hardship 
when a personal residence is sold, particularly when the sale is neces- 
sitated by such circumstances as an increase in family size or change 
in the place of employment. The Senate Committee Report noted 
that sales in these circumstances are particularly numerous in periods 
of rapid change such as mobilization or reconversion (presumably 
referring to wartime conditions). 

Further Comment 

Many have questioned the taxation of any gain from the sale of a 
personal residence, particularly since the tax law does not allow the 
deduction of personal capital losses and because the purchase of a per- 
sonal residence is less of a profit motivated investment than many 
other types of investment. On the other hand, tax deferral of gain 
from home sales does favor investment in homes as compared to 
other types of investment and, along with other features of the tax 
law, contributes to the general favorable treatment afforded home- 
owners in the tax law. 

Selected Bibliography 

U.S. Congress, House, Committee on Ways and Means, Panel 
Discussions. General Tax Reform, Part 2 — Capital Gains and Losses 
(note, particularly, testimony of Kenneth B. Sanden, p. 254). 



DEDUCTIBILITY OF MORTGAGE INTEREST AND 
PROPERTY TAXES ON OWNER-OCCUPIED 
PROPERTY 



Estimated Revenue Loss 

[In millions of dollars] 







Corpora- 
tions 




Fiscal year 


Individuals 

Property Mortgage 
taxes interest 


Total 


1977 

1976 

1975 


__ 3,825 4,710 
__ 3,690 4, 545 
__ 4,510 5,405 




8,535 
8,235 
9,915 



Sections 163 and 164, 



Authorization 



Description 



A taxpayer may take an itemized deduction for mortgage interest 
and property tax paid on his owner-occupied home. 

Impact 

The deduction of nonbusiness mortgage interest and property 
taxes allows homeowners to reduce their housing costs; tenants 
have no such opportunity because they cannot deduct rental pay- 
ments. 1 High income individuals receive greater proportional 
benefits than low income persons, not only because of higher marginal 
tax rates, but also because higher income taxpayers are more likely 
to own one or more homes (and higher income people are likely to 
own higher priced homes with larger mortgages and higher property 
taxes) and to itemize deductions. 

These provisions encourage home ownership by reducing its cost in 
comparison to renting. Some observers believe that these deductions, 
together with other favorable income tax provisions accorded to 
homeowners, have been an important factor in the rapid rise of home- 
ownership since World War II. Other observers suggest that the hous- 
ing market has adjusted for these deductions and that home price 
increases have compensated for the tax benefit. 

1 In contrast to the rental income paid to a landlord by a tenant, the rental value of an 
owner-occupied home is not imputed — i.e. not included — in the income of the owner. Such 
income thus is tax exempt, but the mortgage interest and property tax expense of earning 
it is allowed as a deduction from other taxable income. These deductions favor investment 
in owner occupied homes over investments in residential rental property or other assets 
such as securities. 

(75) 
f;--?,12 — 76 



76 

To the extent that the deductibility of State and local property 
taxes allows these taxes to be higher than they would otherwise be, 
the provision has an effect similar to a revenue sharing program. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 





Percentage distribution 


Adjusted gross income class 


Property 
taxes 


Mortgage 
interest 


to $7,000 


2.2 


1.3 


r $7,000 to $15,000 


19.8 


23.6 


$15,000 to $50,000 


62.7 


65.9 


$50,000 and over 


15.3 


9.1 









Rationale 

Generally, the deductibility of interest and of State and local taxes 
has been a characteristic of the Federal income tax structure since the 
Civil War income tax. An explicit rationale was never advanced, but 
close examination of the legislative histories suggests that these pay- 
ments were viewed as reductions of income. No distinction was made 
between business and nonbusiness expenses. There is no evidence that 
deductibility of these items was originally intended to encourage home 
ownership or to subsidize the housing industry, which is the present 
justification offered for this treatment. 

The Code was revised in 1964 to specify the types of nonbusiness 
taxes which could be deducted. The treatment for property taxes was 
retained because removing the deduction would have precipitated a 
large shift in overall tax burdens. 

Selected Bibliography 

Goode, Richard. The Individual Income Tax, Rev. Ed., The Brook- 
ings Institution, Washington, D.C., 1976, pp. 117-25. 

Aaron, Henry. Who Pays the Property Tax, The Brookings Institu- 
tion, Washington, D.C., 1975. 

"Federal Housing Subsidies," U.S. Congress, Joint Economic Com- 
mittee, The Economics of Federal Subsidy Programs, Part 5 — Housing 
Subsidies, October 9, 1972, pp. 571-96. 

Laidler, David, "Income Tax Incentives for Owner-Occupied 
Homes/' Taxation of Income From Capital. Bailey and Harberger, 
eds. Washington, D.C., The Brookings Institution, 1969, pp. 50-76. 



EXEMPTION OF CREDIT UNIONS 

Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 





135 
125 
115 


135 
125 
115 



Authorization 

Section 501(c) (14). 

Description 

Credit unions without capital stock, and organized and operated 
for mutual purposes and without profit, are not subject to Federal 
income tax. 

Impact 

Because their income is exempt from the income tax, credit unions 
are treated more favorabty than are competing financial institutions 
whose income is taxed. On the other hand, credit unions are subject 
to certain special constraints not required of their competitors, such 
as limits on the interest rate charged on loans, on the duration of loans, 
and on the types of investments that are allowed. In addition, credit 
unions may lend only to members ; however, only a small deposit may 
be required for membership that qualifies the member for a loan 
greatly in excess of the deposit. 

Rationale 

Credit unions have never been subject to the Federal income tax. 
Initially, they were included in the provision that exempted domestic 
building and loan associations — -whose business was at one time 
confined to lending to members — and nonprofit cooperative banks 
operated for mutual purposes. The exemption for mutual banks and 
savings and loan institutions was removed in 1951, but credit unions 
retained their exemption. No specific reason was given for continuing 
the exemption of credit unions. 

Selected Bibliography 

Gelb, Bernard A., Tax Exempt Business Enterprise, The Conference 
Board, New York, 1971. 

U.S. Congress, House, Committee on Ways and Means, "Some 
Considerations on the Taxation of Credit Unions" Prepared by John 
T. Crotean for the House Committee on Wa}^ and Means, Tax 
Revision Compendium, Vol. 3, 1959, pp. 1833-66. 

(77) 



DEDUCTIBILITY OF INTEREST ON CONSUMER 

CREDIT 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal 


year 


Individuals Corporations 


Total 


1977_. 
1976.. 
1975_. 




. 1,075 

. 1,040 

. 1,185 


1,075 
1,040 
1, 185 


Section 163. 




Authorization 
Description 





A taxpayer may take an itemized deduction for interest paid or 
accrued on nonbusiness indebtedness (for example, personal and auto 
loans and credit account purchases). 

Impact 

This provision reduces net interest charges and thereby reduces the 
price of consumer purchases financed by debt. If the purchase is an 
asset that earns income, that is then subject to tax (e.g., borrowing 
to purchase mutual fund shares), the interest charge is an expense of 
earning income and it would cusomarily be deductible as an invest- 
ment expense. For other items the interest deduction acts as a subsidy 
and thus encourages their purchase, financed by borrowing. Because 
higher income taxpayers are more likely to itemize deductions, they 
are more likely to benefit from this provision than are taxpayers in 
lower brackets. 

Under 1954 legislation, the deduction for carrying charges on most 
consumer credit (unless explicitly denominated "interest") was 
limited to about 6 percent on the declining balance of consumer debt. 
In more recent years, bank charge cards have proliferated, and the 
Internal Revenue Service has ruled that charges on those cards 
generally can be fully deducted as interest. On the other hand, pur- 
chases under deferred payment contracts usually remain subject to 
the limitation already mentioned. Thus, the theoretical treatment of 
bank charge cards differs substantially from deferred payment sales 
where carrying charges are often not called "interest." Whether this 
distinction is observed in practice is unknown. 

(79) 



80 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 

Adjusted gross income class (thousands of dollars) : distrioution 

0to7 _ 1.4 

7 to 15 _ _ _ 23. 7 

15 to 50 _ 66. 

50 and over 9. 

Rationale 

While the 1862 income tax statute did not contain a special provision 
for the deduction of interest, it was allowed. When the income tax 
was reinstituted in 1913, a special provision allowing the deduction of 
interest was included, apparently because of concern that interest 
might not be treated as a business expense and deducted under the 
general business expense provision. At that time, no distinction was 
drawn between business and nonbusiness interest expense, presumably 
because the latter constituted a very small proportion of total interest 
expense. However, today the nonbusiness interest cost is perceived as 
a consumption item and hence different from business interest. 

Selected Bibliography 

Kahn, C. Harry. Personal Deductions in the Federal Income Tax, 
Princeton, Princeton University Press, 1960, pp. 109-24. 



CREDIT FOR PURCHASING NEW HOME 

Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


100 
625 




100 
625 



Authorization 

Section 44. 

Description 

A credit against tax liability is allowed for 5 percent of the purchase 
price of a "new principal residence" purchased after March 12, 1975, 
and before January 1, 1976. The maximum amount of the credit is 
$2,000 or tax liability for 1975, whichever is less. Only houses on which 
construction began before March 26, 1975, are eligible. Single family 
houses, condominium and cooperative units, and mobile homes all 
qualify. The purchase price may be no higher than it was on Feb- 
ruary 28, 1975. 

Example 

A taxpayer who purchases a new home in July 1975 costing $40,000 
or more may claim a credit of $2,000 against his income tax for 1975. 
If his tax for 1975 is $3,000, the $2,000 credit can be subtracted directly 
from the tax and the tax due will be only $1,000. If the purchase 
price 1 of the house is less than $40,000, the credit will be 5 percent of 
the purchase price. The amount of the credit may not exceed tax 
liability. Thus, if a taxpayer earns a credit of $2,000 but owes a tax 
of only $1,500, the credit will be $1,500. 

Impact 

The distribution of the tax savings by income class will not be known 
until 1975 tax returns are filed and analyzed. While some portion of 
the benefit from the credit will be received by home sellers who did not 
reduce their asking price as much as they would have otherwise, home 
buyers — particularly those with taxable income above $20,000 — will 
also benefit. Some families who qualify will not receive the full amount 
of the credit because their tax liability will be less than the credit. 
For example, for a family of four, tax liability begins only when income 
reaches nearly $6,000, and tax liability does not amount to $2,000 until 
income is about $17,500. 



1 In calculating the amount of the credit, the purchase price must be reduced by the 
amount of gain on the sale of a previous residence unless tax is paid on the gain. 

(81) 



82 

The impact of the credit on housing and on the economy is difficult 
to measure because it cannot be isolated from the other factors at 
work in the housing industry at the same time. Some initial evidence in- 
dicates the credit had little or no favorable impact on the inventory of 
unsold new houses, new home sales, housing starts, or construction 
industry employment. 1 On the other hand, evidence cited by the home 
building industry indicates the credit did have an impact on home 
sales. 

Rationale 

The home purchase tax credit was enacted as part of the Tax 
Reduction Act of 1975. Its purpose was described as primarily to 
reduce the existing inventory of unsold new homes. 

Selected Bibliography 

U.S. Congress, Senate, Senate Report No. 94-36, March 17, 1975, 
p. 12. 

U.S. Congressional Budget Office, "An Analysis of the Impact of 
the $2,000 Home Purchase Tax Credit" (processed November 20, 
1975). 



1 Federal Home Loan Bank Board Newsletter, Oct. 14, 1975 ; Secretary of Housing and 
Urban Development Carla Hills, testimony before tbe Senate Committee on Banking, Hous- 
ing and Urban Affairs, Nov. 5, 1975. 



HOUSING REHABILITATION: 5-YEAR 
AMORTIZATION 

Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 


40 


25 


65 


1976 


55 


35 


90 


1975 


65 


40 


105 



Section 1 67 (k). 



Authorization 



Description 



In lieu of depreciation, certain expenditures incurred to rehabilitate 
low or moderate income rental housing may be amortized over five 
years using the straight line method and no salvage value. This rapid 
amortization is permitted only with respect to expenditures incurred 
after July 24, 1969, and before 1976, or, if made under a pre-1975 
binding contract, before 1978. Moreover, the write-off is available only 
where during a period of two consecutive years, expenditures exceed 
$3,000 per unit, and applies only to expenditures not in excess of 
$15,000 per rental unit. The use of 5-year amortization for assets 
whose useful lives are longer benefits the taxpayer by effectively 
deferring current tax liability (see Appendix A) . 

Example 

Assume a taxpayer spends $10,000 on structural rehabilitation of a 
low or moderate income rental housing with a useful life of 20 years. 
Without the amortization provision (using the double declining 
balance method of computing depreciation), his deduction in the 
first year would be : 

200 percentX&)X$10,000 = $l,000 
In the second year his depreciation would be: 

200 percentX&)X$9,000 = $900 
The deductions for depreciation would continue in smaller amounts 
over the remaining life of the asset. 

With five-year amortization, one-fifth of the amount ($2,000) is 
deducted each year for 5 years. Afterwards no additional deduction 
for amortization or depreciation may be taken. 

(83) 



84 

Impact 

The tax benefit accrues to investors in projects to rehabilitate low 
and moderate income housing; about 60 percent of the tax relief goes 
to individual taxpayers. Even though the properties in question may 
not be currently earning income, the rapid amortization may be de- 
ducted against other income from housing investments and may pro- 
vide a tax shelter for totally unrelated income. Low income renters 
benefit only to the extent that rehabilitated units rent for less than 
new units of comparable quality, or to the extent that more units are 
rehabilitated than would be otherwise. The very small amount of 
evidence available does not indicate a flow through of tax benefits to 
the renters. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 1 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

Oto 7 4.0 

7 to 15 4. 

15 to 50 16. 

50 and over 76. 

1 The distribution refers to the individual tax expenditure only. The corporate tax expend- 
iture resulting from this tax provision is not reflected in this distribution table. 

Rationale 

This provision was adopted as part of the Tax Eeform Act of 1969 
as a temporary provision to stimulate rehabilitation of low and 
moderate income housing. It was subsquently extended for 1 year by 
P.L. 93-625 (January 3, 1975). Although it expired December 31, 
1975, a retroactive reinstatement may be passed in 1976. 

Selected Bibliography 

Heinberg, John D. and Emil M. Sunley, Jr., "Tax Incentives for 
Kehabilitating Rental Housing," in Housing 1971-1972. AMS Press 
(1974). Reprinted as Urban Institute Reprint, URI-10122. 

McDaniel, Paul R. "Tax Shelters and Tax Policy." National Tax 
Journal, Vol. XXVI, No. 3, September 1973, pp. 353-88. 

Surre}^ Stanley S. Pathways to Tax Reform. Cambridge, Massa- 
chusetts, Harvard University Press, 1973. Chapter VII — Three 
Special Tax Expenditure Items: Support to State and Local Gov- 
ernments, to Philanthrop}^, and to Housing, pp. 209-46. 

U.S. Congress. House Committee on Ways and Means. General 
Tax Reform, Panel Discussions. 93rd Congress, 1st Session. Part 
4— Tax Treatment of Real Estate, February 8, 1973 and Part 6— 
Minimum Tax and Tax Shelter Devices, February 20, 1973, pp. 
507-611 and 697-912. 

U.S. Congress, House Committee on Ways and Means, Tax Reform! 
Hearings, Part 2. Panels Nos. 1 and 2 — Tax Shelters and Minimum 
Tax, July 16, 1975, pp. 1403-1607. 



FIVE YEAR AMORTIZATION OF CHILD CARE 

FACILITIES 



Estimated Revenue Loss 



[In millions of dollars] 




Fiscal year Individuals Corporations 


Total 


1977 5 

1976 5 

1975 5 


5 
5 
5 


Authorization 

Section 188. 

Description 





Irrlieuof depreciation, an employer may amortize, on a straight line 
basis over 60 months, capital expenditures to acquire, construct, re- 
construct, or rehabilitate property that qualifies as an employee 
child care facility. The types of facilities which qualify are described 
generally by regulation as those where children of employees receive 
personal care, protection, and supervision in the absence of their 
parents. Section 188 applies only to expenditures made after Decem- 
ber 31, 1971, and prior to January 1, 1977. The investment credit 
cannotjbej^lainied for property subject to this amortization. 

Impact 

As with any rapid amortization provision, the taxpayer is allowed 
to defer some current tax liability (see Appendix A). The effect of this 
provision in increasing the number of child care facilities is unclear. 

Rationale 

This tax benefit, adopted in 1971, is intended to encourage em- 
ployers to provide more child care facilities for children of single 
parents and working mothers. 

Selected Bibliography 

U.S. Congress. Joint Committee on Internal Revenue Taxation. 
General Explanation of the Revenue Act of 1971, H.R. 10947, 92d 
Congress, P.L. 92-178, December 15, 1972, Washington, D.C., U.S. 
Government Printing Office, 1972, pp. 62-4. 

U.S. Department of Labor, Women's Bureau, Day Care Services? 
Industry's Involvement, Bulletin 296, Washington, D.C., U.S. Govern- 
ment Printing Office, 1971, p. 33. 

Maymi, Carmen R. "Working Mothers — Their Child Care Needs." 
Address delivered at meeting of the Chicago Community Coordinated 
Child Care Committee. Chicago, Illinois, November 2, 1974. 

(85) 



EXCLUSION OF SCHOLARSHIPS AND 
FELLOWSHIPS 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 ___ _. 


220 
210 
200 




220 


1976 




210 


1975 




200 









Section 117. 



Authorization 



Description 



Generally, individuals may exclude from taxable income amounts 
received as scholarships or fellowships. The exclusion includes amounts 
received to cover such incidental expenses as travel, research, clerical 
assistance, or equipment, but does not apply to any amount received 
as payment for teaching, research, or similar services. The amount 
that degree candidates may exclude is unlimited. Scholarships and 
fellowships for nondegree candidates may be excluded only if the 
grantors meet certain requirements; further, the amount that they 
may exclude is limited. 

Impact 

The value of the tax benefit received by each recipient of a tax 
exempt scholarship or fellowship grant is small in many cases because 
grants are of modest amounts and the recipients have little or no tax 
liabilit}". 

However, the amount of the tax benefit increases with the in- 
dividual's tax bracket, and therefore, increases with the existence of 
other income such as a spouse's earnings. Furthermore, university 
professors often convert sabbatical pay into tax free fellowships. 



Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

a t l i • i /i , ■, ii x Percentage 

Adjusted gross income class (thousands of dollars) : distribution 

0to7 47.7 

7 to 15 36.9 

15 to 50 15. 4 

50 and over 

(87) 



88 

Rationale 

Prior to the Internal Revenue Code of 1954, scholarships were in- 
cluded in income unless the taxpayer could show that the grant was a 
gift. This treatment was considered to lack uniformity. The ostensible 
purpose of the exclusion was to make treatment of taxpayers con- 
sistent and uniform. The only amendment to this section, made in 
1961 (P.L. 87-256), expanded the category of qualifying grantors of 
nondegree candidates' scholarships and fellowship grants. 

Selected Bibliography 

U.S. Congress, House Committee on Ways and Means. Internal 
Revenue Code of 1954, Report to Accompany H.R. 8300, A Bill to Revise 
the Internal Revenue Laws oj the United States, Washington, D.C., 
U.S. Government Printing Office, 1954, pp. 16-17, A37-A38 (83rd 
Congress, 2nd Session, House Report No. 1337). 

U.S. Congress, Senate Committee on Finance. Internal Revenue 
Code of 1954, Report to Accompany H.R. 8300, A Bill to Revise the 
Internal Revenue Laws of the United States, Washington, D.C., U.S. 
Government Printing Office, 1954, pp. 17-18, 188-90 (83rd Congress, 
2nd Session, Senate Report No. 1622). 



PARENTAL PERSONAL EXEMPTION FOR 
STUDENT AGE 19 OR OVER 



Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals Corporations 


Total 


1977 . __. 


715 


715 


1976 


690 


690 


1975 


670 


670 









Section 151(e), 



Authorization 



Description 



A taxpayer is allowed to deduct $750 as an exemption for each 
dependent. A person with gross income in excess of $750 may not be 
claimed as a dependent unless that person is the child of the taxpayer 
and is either (a) less than 19 years of age or (b) a full-time student. 
Unless support is provided by several taxpayers, a person is a depend- 
ent only if the taxpayer claiming him as a dependent provided more 
than one-half of the person's support. 

Impact 

This provision benefits families with tax liability and with children 
who are students and have earnings. The value of each $750 personal 
exemption deduction is $525 for families with the highest marginal 
tax rate of 70 percent and $150 for families taxed at the median 
marginal rate of 20 percent. No relief is available to the parents of 
students who provide more than one-half of their own support. 
Therefore, parents are aided by this dependency exemption if their 
student-children do not rely on their earnings or other income to 
provide a majority of their support. 



Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 

Adjusted gross income class (thousands of dollars) : distribution 

to 7 7. 

7 to 15 47. 6 

15 to 50 31. 

50 and over 14. 4 

(89) 



90 

Rationale 

A personal exemption for dependents was first provided by the 
Revenue Act of 1918, apparently to provide some tax relief for parents 
supporting young children or students. The definition of a dependent 
was revised over the years and a gross income test was added in 1944. 
The 1954 revision of the Internal Revenue Code eliminated the 
gross income test for dependent children under the age of 19 and 
dependent children of any age who were students. Except for increases 
in the amount of the exemption to $750, this provision has been 
unchanged since 1954. 

Selected Bibliography 

U.S. Congress, House, Committee on Ways and Means. Internal 
Revenue Code of 1954, Report to Accompany H.R. 8300, A Bill to 
Revise the Internal Revenue Laws of the United States, Washington, 
D.C., U.S. Government Printing Office, 1954, pp. 18-9, A40-A41, 
Tax Revision Compendium. Papers on Broadening the Tax Base, 
November 16, 1959, vol. 1, Washington, D.C, U.S. Government 
Printing Office, pp. 533-4. 

Groves, Harold M. Federal Tax Treatment of the Family, The Brook- 
ings Institution, Washington, D.C, pp. 39-43. 

Seltzer, Lawrence H. The Personal Exemption in the Income Tax, 
National Bureau of Economic Research, New York, 1968, pp. 113-20. 



• 



DEDUCTIBILITY OF CHARITABLE 
CONTRIBUTIONS 

(1) Educational Institutions 
(2) Other Than Educational Institutions 

Estimated Revenue Loss 

[In millions of dollars] 





Individuals 


Corporations 

Educa- Other 
tional 




Fiscal year 


Educa- 
tional 


Other 


Total 


1977 

1976 

1975 


_ 500 
_ 450 
_ 440 


3, 955 
3,820 
4,385 


280 
215 
205 


525 

395 
385 


5,260 
4,880 
5, 415 



Authorization 

Sections 170 and 642(c). 

Description 

Subject to certain limitations, charitable contributions may be 
deducted by individuals, corporations, and estates and trusts. 

The contributions must be made to specific types of organizations 
including charitable, religious, educational and scientific organiza- 
tions, and Federal, State, and local governments. 

Individuals may itemize and deduct qualified contributions amount- 
ing up to 50 percent of their adjusted gross income (AGI); however, 
the deduction for gifts of appreciated property is limited to 30 percent 
of AGI. In the case of a corporation, the limit is 5 percent of taxable 
income (with some adjustments). 

Impact 

The deduction for charitable contributions reduces tax liability 
and thus makes the net cost of contributing less than the amount of 
the gift. In effect, the Federal Government provides the donee with 
a matching grant which, per dollar of contribution, increases in 
value with the donor's tax bracket. Thus, a taxpayer in the 70 percent 
bracket who itemizes deductions can contribute $100 to a charitable 
organization at a net cost of $30 while one in the 20 percent bracket 
can contribute the same amount at a net cost of S80. An individual 
who takes the standard deduction or a non-taxpayer receives no 
benefit from the provision. 

(91) 

67-312—76 7 



92 

Types of contributions may vary substantially among income 
classes. Contributions to religious organizations are far more con- 
centrated at the lower end of the income scale than contributions to 
hospitals, the arts, and educational institutions, with contributions 
to other types of organizations falling between these levels. However, 
the volume of donations to religious organizations is greater than to 
all other organizations as a group. 

Organizations that receive the contributions (and their clients) 
benefit from this provision to the extent it increases charitable giving. 
Empirical studies have not reached a consensus as to how much the 
deduction encourages charitable contributions and how the deduction 
affects the composition of contributions. Tentative conclusions are 
that the deduction increases charitable giving by more than the 
forgone Treasury revenue, and that it favors educational contribu- 
tions relatively more than would a tax credit or a matching grant 
program outside the tax system. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 1 





Percentage distributions 


Adjusted gross income class 


Educational Other 


to $7,000.. 


0.3 2.3 


$7,0G0 to $15,000 


1.4 16.6 


$15,000 to $50,000. 


23.7 47.1 


$50,000 and over 


74.6 34.0 





1 The distribution refers to the individual tax expenditure only. The corporate tax expend- 
iture resulting from these tax provisions is not reflected in this distribution table. 

Rationale 

This deduction was added on the Senate floor in 1917. Senator 
Hollis, the sponsor, argued that the war and high wartime tax rates 
had an adverse impact on the flow of funds to charitable organizations. 
He preferred a tax deduction to a direct Government subsidy. The 
deduction was extended to estates and trusts in 1918 and to corpora- 
tions in 1935. 

Selected Bibliography 

Bittker, Borris, "Charitable Contributions: Tax Deductions or 
Matching Grants?" 28 Tax Law Review 37 (1972). 

Feldstein, Martin, "The Income Tax and Charitable Contributions: 
Part I — Aggregate and Distributional Effects", National Tax Journal, 
March 1975, pp. 81-11; "The Income Tax and Charitable Contribu- 
tions: Part II — The Impact on Religious, Educational, and Other 
Organizations", National Tax Journal, June 1975, pp. 209-226. 

McDaniel, Paul R., "Federal Matching Grants for Charitable 
Contributions: A Substitute For The Income Tax Deduction", 27 
Tax Law Review 377 (1972) . 



93 

Surrey, Stanley R., Pathways to Tax Bejorm, Chapter VII — Three 
Special Tax Expenditure Items: Support to State and Local Govern- 
ments, to Philanthropy, and to Housing", Cambridge, Massachusetts, 
Harvard University Press, 1973, pp. 209-46. 

National Tax Association — Tax Institute of America. Tax Impacts 
on Philanthropy — a Symposium. Washington, D.C., December 2-3, 
1972. Princeton: NTA-TIA and Fund for Public Policy Research, 
1972. 

Commission on Private Philanthropy and Public Needs, John H. 
Filer, Chairman, Giving in America: Toward a Stronger Voluntary 
Sector, 1975. 



DEDUCTIBILITY OF CHILD AND DEPENDENT 
CARE SERVICES 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


_ 420 
_ 330 
_ 295 




420 
330 
295 



Authorization 

Section 214. 

Description 

A taxpayer may deduct certain expenses to care for a dependent 
child (under age 15), disabled dependent or spouse, or for household 
services when the taxpayer maintains a household for them. Deductible 
expenses are those incurred to enable the taxpayer to be gainfully 
employed full-time. The services must be rendered in the home, 
except for dependent children. 

The deduction generally is limited to $400 a month. However, the 
monthly deduction limit for services rendered outside the home i^ $200 
for one child, $300 for two children, and $400 for three or more children. 

To claim the deduction, a husband and wife both must be employed 
full time unless one spouse is disabled. 

For 1976 and later years, the deduction is reduced by $1.00 for each 
dollar of adjusted gross income (AGI) over $35,000; thus, the maxi- 
mum deduction is entirely phased out when AGI equals $44,600. 

Impact 

Only taxpayers who itemize deductions may take advantage of 
this provision. Thus, taxpayers with moderate child care expenses 
and low levels of income are not likely to receive much tax relief 
from this provision, while high income taxpayers receive no relief 
from the provision at all because of the phase-out. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Adjusted gross income class (thousands of dollars) : distribution 

to7 3. 5 

7 to 15 50. 4 

15 to 50 46. 1 

50 and over 

(95) 



96 

Rationale 

The deduction for child and dependent care services originated in 
1954. The allowance was limited to $600 per year and was phased 
out for those with family income between $4,500 and $5,100. The 
intent of the provision was to provide for the deduction of expenses 
comparable to an emplo3 r ee's business expenses in cases where tax- 
payers must incur such expenses. 

The provision was made more generous in 1964 and modified in 
1971. The Tax Reduction Act of 1975 substantially increased the 
income limits. 

Several new justifications were specified in 1971 including encourag- 
ing the hiring of domestic workers, encouraging the care of incapac- 
itated persons at home rather than in institutions, providing relief to 
middle income taxpayers as well as low income taxpayers, and provid- 
ing relief for employment-related expenses of household services as 
well as for dependent care. Thus, there was a departure from earlier 
intent that only "essential" expenditures for such service- should be 
deductible. 

Further Comment 

Numerous proposals have been made to treat expenses for household 
service and dependent care as business rather than personal expense 
and, thus, eliminate the necessity to itemize the deduction in order to 
benefit. The substitution of a credit for a deduction was adopted by 
the House in H.R. 10612 in December 1975. 

Selected Bibliography 

Greenwald, Carol S. and Linda G. Martin, Broadening the Child 
Care Deduction: How Muck Will It Cost? Federal Reserve Bank of 
Boston, September/October 1974, pp. 22-30. 

Keane, John B., "Federal Income Tax Treatment of Child Care 
Expenses," Harvard Journal of Legislation, December 1972, pp. 1-40. 

Klein, William A., "Tax Deductions for Family Care Expenses," 
Boston College Industrial and Commercial Law Beview, Mav 1973, pp. 
917-41. 



CREDIT FOR EMPLOYING PUBLIC ASSISTANCE 
RECIPIENTS UNDER WORK INCENTIVE (WIN) 
PROGRAM 



Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


10 

10 

10 


10 
10 
10 


Authorization 

Sections 40, 50A, and 50B. 





Description 

Taxpayers are allowed a credit against their tax liability equal to 20 
percent of the wages paid or incurred with respect to Federal welfare 
recipients in the aid to dependent children (AFDC) program who 
are hired under the Work Incentive Program (WIN). 

The WIN credit may not exceed $25,000 plus 50 percent of any tax 
liability over $25,000 in any one taxable year. Excess credits may be 
applied to past and future tax liability ; the credit may be carried back 
3 years and forward 7 years. 

In 1975 the credit was temporarily expanded to apply to wages paid 
AFDC recipients who were not in the WIN program for services 
rendered to employees before July 1, 1976. 

Impact 

The WIN tax credit operates as a wage subsidy by providing tax 
relief for emplo3'ers who hire eligible employees. Participating em- 
ployees benefit, as does the general taxpayer to the extent that em- 
ployment and earnings are increased by the program and welfare 
payments are reduced. But, other things being eaual, individuals not 
enrolled in this program may be at a disadvantage when seeking 
employment. 

Income tax data for 1972 indicate that slightly more than half of 
the corporate claims for the credit were by corporations with assets 
of $250 million or more; about 60 percent was claimed by the manu- 
facturing sector (nearly 25 percent by the auto industry), followed by 
about 15 percent in wholesale and retail trade. 

(97) 



98 

Rationale 

WIN was created by Congress in 1967 to encourage private em- 
ployers to hire and train welfare recipients. The WIN tax credit was 
created by the Revenue Act of 1971 to further encourage employers 
to hire welfare recipients and was extended in 1975 temporarily to 
AFDC welfare payment recipients, regardless of participation in the 
WIN program, again to encourage employment practices that would 
reduce welfare payments. 

Selected Bibliography 

U.S. Congress, The Joint Committee on Internal Revenue Taxation 
General Explanation of the Revenue Act of 1971, H.R. 10947, 92 d 
Congress, Public Law 92-178, December 15, 1972. 



EXCLUSION OF EMPLOYER CONTRIBUTIONS 
TO MEDICAL INSURANCE PREMIUMS AND 
MEDICAL CARE 



Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


4,225 

. 3,665 

. 3,275 


4,225 
3,665 
3,275 



Section 106. 



Authorization 



Description 



Employees do not pay tax on their employers' contributions to 
accident and health plans which compensate them for sickness and 
injury. 

Impact 

The exclusion for the employer's contribution to emplo3~ee health 
insurance plans benefits all taxpayers who participate in a plan. 
Because of the exemption, employers can provide the insurance cov- 
erage at less cost than they would have to pay in taxable wages for 
employees to purchase an equal amount of insurance. Thus, in effect, 
the provision reduces the employee's net after-tax price of obtaining 
health insurance and health services. The exclusion is worth more the 
higher the taxpayer's marginal tax rate. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 

Adjusted gross income class (thousands of dollars) : distribution 

to 7 7. 8 

7 to 15 32. 2 

15 to 50 50. 4 

50 and over 9. 6 

Rationale 

Prior to the adoption of the Internal Revenue Code of 1954, amounts 
paid b} r employers for group employee insurance were excluded from 
gross income of the employee. However, amounts paid for individual 
policies were included. Section 106 equalized the tax treatment of 
contributions to the various funds by exempting them all. 

(99) 



100 

While the objective of the original group policy exemption is not 
clear, the current treatment is justified as indirect Federal assistance 
to help pay for the health insurance of taxpayers. 

Selected Bibliography 

Feldstein, Martin and Elizabeth Allison, 'The Tax Subsidies of 
Private Health Insurance Distribution, Revenue Loss and Effect," in 
U.S. Congress, Joint Economic Committee, The Economics oj Federal 
Subsidy Programs, Part 8 — Selected Subsidies, July 29, 1974, pp. 977- 
94. 

Davis, Karen. National Health Insurance: Benefits, Costs, and 
Consequences, The Brookings Institution, Washington, D.C., 1975, 
182 pages. 

Goode, Richard. The Individual Income Tax, Rev. ed., The Brook- 
ings Institution, Washington, D.C., 1976, pp. 156-60. 



DEDUCTIBILITY OF MEDICAL EXPENSES 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


. 2, 095 
2, 020 
2, 315 




2, 095 
2,020 
2,315 



Section 213. 



Authorization 



Description 



Medical expenses paid by an individual may be itemized and 
deducted from income to the extent they exceed 3 percent of adjusted 
gross income (AGI). In computing medical expenses, amounts paid 
for medicine and drugs may be taken into account only to the extent 
they exceed 1 percent of AGI. In addition, the 3 percent floor not- 
withstanding, an amount — not in excess of $150 per year — equal to 
one-half of medical insurance premiums for the year ma} 7 be deducted. 

Impact 

For taxpayers who itemize their deductions, this provision reduces 
the net (after-tax) price of health insurance and health services. The 
deduction is worth more the higher the taxpayer's marginal tax rate. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

Oto 7 7.2 

7 to 15 35. 1 

15 to 50 47. 5 

50 and over 10. 2 

Rationale 

Health costs in excess of a given floor were first allowed as a deduc- 
tion in 1942 in order to maintain high standards of public health and 
to ease the burden of high wartime tax rates. Originally, the deduction 
was allowed only to the extent that medical expenses exceeded 5 
percent of AGI (considered to be the average family medical expense 
level), and was subject to a $2,500 maximum. In 1951, the floor was 
removed for taxpayers 65 or over. In 1954, when the Internal Revenue 

(101) 



102 

Code was substantially revised, the percentage of AGI was reduced 
to 3 percent and the 1 percent floor was imposed on drugs and medicines. 
The dollar coiling was increased several times until it was finally 
eliminated in 1965. In that year, the aged were made subject to the 
floor and deductions for health insurance premiums were allowed 
without a floor. Since insurance premiums help to even out health ex- 
penditures and make it less likely that such expenses can be deducted, 
it was reasoned that half the cost of insurance premiums should be 
outside the floor to prevent the tax system from discouraging the 
purchase of health insurance. 

Further Comment 

Tax deductions and exclusions related to health care may affect the 
pattern of purchase of medical services, particularly the purchase of 
medical care through insurance. While tax subsidies for medical care 
provide financial relief for some taxpayers who itemize unusually 
large medical expenses (the relief being greater the higher the tax 
bracket), at the same time, these subsidies may encourage the pur- 
chases of medical services and thus contribute to the bidding up of 
prices for those services. However, alternative programs to provide 
national health insurance also may result in bidding up the price of 
these services. 

Selected Bibliography 

Feldstein, Martin and Elizabeth Allison, "The Tax Subsidies of 
Private Health Insurance Distribution, Revenue Loss and Effect,' ' in 
U.S. Congress, Joint Economic Committee, The Economics of Federal 
Subsidy Programs, Part 8 — Selected Subsidies, July 29, 1974, pp. 
977-94. 

Davis, Karen. National Health Insurance: Benefits, Costs, and 
Consequences, The Brookings Institution, Washington, D.C., 1975, 
182 pages. 

Goode, Richard. The Individual Income Tax, Rev. ed. The Brook- 
ings Institution, Washington, D.C., 1976, pp. 156-60. 

Mitchell, B. M. and R. J. Vogel, Health and Taxes: An Assessment 
of the Medical Deduction, R-1222-OEO, The Rand Corporation, Santa 
Monica, Calif., August, 1973. 



EXCLUSION OF SOCIAL SECURITY BENEFITS 



Disability Insurance Benefits, OASI Benefits for the 
Aged, and Benefits for Dependents and Survivors 

Estimated Revenue Loss 

[In millions of dollars] 



Individuals 



Benefits 
Disa- OASI for Cor- 

Fiscal bility benefits depend- pora- 
year in- for aged ents and tions Total 

surance survi- 

benefits vors 



1977 


370 


3, 


525 


565 _. 


.. 4,460 


1976 


315 


3, 


045 


495 -. 


— 3,855 


1975 


275 


2, 


740 


450 ._ 


._ 3,465 



Authorization 

I.T. 3194, 1938-1 C.B. 114 and IT. 3229, 1938-2136, as superseded 
by Rev. Rul. 69-43, 1969-1 C.B. 310; I.T. 3447, 1941-1 C.B.*191,as 
superseded by Rev. Rul. 70-217, 1970-1 C.B. 12. 

Description 

Social security benefits to persons who are aged, disabled, or the 
widow or widower of a spouse who participated in the system, are 
not included in gross income and thus are tax exempt. 

Impact 

The elderly benefit most from this treatment, since most social 
security payments are made to the elderly. The tax saving per dollar of 
exclusion increases with the marginal rate of the taxpa3 T er. Therefore, 
the exemption is worth much less to a recipient whose income comes 
solely from social security benefits, than to recipients with substantial 
amounts of taxable income. Note that the supplemental security 
income program (SSI) provides direct income support to only low- 
income aged, blind, and disabled persons. 

(103) 



104 



Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 





Percentage distribution 


Adjusted gross income class 


Disability 

insurance 

benefits 


OASI 
benefits 
for aged 


Bensfits for 

dependents 

and survivors 


to $7,000 


51.9 


51.8 

31.6 

14.0 

2.6 


52.4 


$7,000 to $15,000 


31.9 


31.7 


$15,000 to $50,000 


14.0 


13.4 


$50,000 and over. 


2.1 


2.4 



Rationale 

The exemption for social security payments has never been estab- 
lished by statute; it derives from administrative ruling I.T. 3447, 
issued in 1941. A Supreme Court decision in 1937 and a 1938 IRS 
ruling regarding lump sum payments were influential in resolving the 
issue. In 1937, the Supreme Court characterized social security as 
"general welfare" (Helvering vs. Davis, 301 U.S. 619, 640). Two 1939 
rulings made lump sum distributions nontaxable (I.T. 3194 and I.T. 
3229); internal memoranda suggested that the payments were con- 
sidered in the nature of a gift. The reasons underlying the 1941 IRS 
ruling on monthly payments appear to include: (1) the benefits are 
gratuities and thus not subject to income tax because gifts are not 
taxable; (2) Congress indicated its intent that the benefits not be 
taxable since it did not specifically make them taxable; and (3) the 
benefits are in the nature of public assistance for the general welfare 
and Congress did not intend to take money from one pocket and put 
it into another. 

Further Comment 

There have been proposals to include these pa^rments in taxable 
income to the extent pa3 r ments exceed employee contributions, and 
to adjust allowances, such as the personal exemption and standard 
deduction (including the low income allowance) to afford tax relief to 
persons below a determined income level. However, the distribution of 
net (after-tax) benefits would generally differ from the distribution 
of nontaxable benefits. Therefore, if benefits were to be made taxable, 
the benefit structure might require adjustment. There also could be 
substantial administrative difficulties in taxing the portion of the 
benefits which exceeded employee contributions. 

Selected Bibliography 

Goode Richard. The Individual Income Tax, Rev. ed. The Brook- 
ings Institution, Washington, D.C., 1976, pp. 103-07. 

Groves, Harold. Federal Tax Treatment of the Family, Chapter III — 
Tax Treatment of the Aged and Blind, The Brookings Institution, 
Washington, D.C., 1964, pp. 47-55. 



EXCLUSION OF RAILROAD RETIREMENT 
BENEFITS 



Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


200 

185 

170 


200 
185 
170 



Authorization 
45 U.S.C. 228, Railroad Retirement Act of 1935, as amended: 

Description 

Benefits paid under the Railroad Retirement Act are tax exempts 

Impact 

This exclusion benefits retired members of the Railroad Retirement 
System. Payments generally are larger than those under social security. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

p€TC€Tttd(]C 

Adjusted gross income class (thousands of dollars) : distribution 

0to7 51.9 

7 to 15 31. 9 

15 to 50 13. 8 

50 and over 2. 5 

Rationale 

While this exclusion has a statutory foundation, the reasons sup- 
porting it have not been stated. Presumably they are similar to those 
stated for social security. (See p. 104, above.) 

Further Comment 

The questions relating to tax treatment of railroad retirement 
benefits are similar to those arising in connection with social security 
benefits. (See p. 104, above.) 

(105) 



106 

Selected Bibliography 

Goode, Richard. The Individual Income Tax, Rev., ed. The Brook- 
ings Institution, Washington, D.C., 1976 pp. 103-07. 

Groves, Harold. Federal Tax Treatment of the Family, Chapter III — 
Tax Treatment of the Aged and Blind, The Brookings Institution, 
Washington, D.C., 1964, pp. 47-55. 



EXCLUSION OF SICK PAY 



Estimated Revenue Loss 







[In millions of dollars] 




Fiscal 


year 


Individuals 


Corporations 


Total 


1977. 




350 
330 
315 




350 


1976 




330 


1975 _ 




315 









Section 105(d). 



Authorization 



Description 



To a limited extent, benefits received by employees (but not self- 
employed individuals) under accident and health plans financed wholly 
or partially by employers may be excluded from gross income. The 
exclusion applies only to amounts paid as wages or as a wage sub- 
stitute during an employee's absence from work due to injury or sick- 
ness. If sick pay exceeds 75 percent of the employee's regular wages, 
amounts attributable to the first 30 days of absence are included in 
income. An empk^ee whose sick pay is 75 percent or less of his regular 
weekly rate of pay may exclude up to $75 a week, starting from the 
first day he is absent if he is hospitalized for at least 1 day, or other- 
wise after 7 days. In all cases, amounts for the period after the first 30 
da3"s can be excluded only up to $100 per week. 

Impact 

The sick pay exclusion is designed to reduce the tax burden of 
individuals during extended illness. It also allows some taxpayers 
to exempt a portion of their disability pensions until they reach normal 
retirement age, whereupon the payments are taxed as pensions. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

P £T CCTltdQ 6 

Adjusted gross income class (thousands of dollars) : distribution 

0to7 16.9 

7 to 15 35. 3 

15 to 50 45. 9 

50 and over 2. 

(107) 



-312— 7( 



108 

Rationale 

The sick pay exclusion was first enacted in 1954. Prior to that time, 
employers' payments to employees under accident and health in- 
surance plans had been excluded from income. According to the 
Ways and Means Committee report, the rationale was to equalize 
the treatment of employer-financed sick pay plans with the treatment 
of payments financed under plans contracted with insurance com- 
panies. The limitations and extended waiting periods were adopted 
in 1964. 

Further Comment 

H.R. 10612, passed by the House in 1975, would limit the sick pay 
exclusion to those who are retired on disability and are permanently 
and totally disabled. 

Selected Bibliography 

Goode, Richard. The Individual Income Tax, Rev. ed. The Brook- 
ings Institution, Washington, D.C., 1976, pp. 107-09. 

W^entz, Roy, "An Appraisal of Individual Income Tax Exclusions," 
in U.S. Congress, House, Committee on Ways and Means, Tax 
Revision Compendium, 1959, pp. 329-40. 



EXCLUSION OF UNEMPLOYMENT INSURANCE 

BENEFITS 



Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


. 2,855 

. 3,305 

. 2,300 


2, 855 

3, 305 
2,300 



Authorization 

I.T. 3230, 1938-2, C.B. 136; Rev. Rul. 70-280, 1970-1 C.B. 13. 

Description 

Taxpayers may exclude unemployment compensation benefits 
from gross income; thus these benefits are not taxed. 

Impact 

The tax benefit from this provision depends upon the amount of 
unemployment compensation received, and the tax savings per dollar 
of tax exempt income increases with the taxpayer's marginal income 
tax bracket. Therefore, the exemption is of little value to a recipient 
with no other sources of income but of increasing value to taxpayers 
with either a spouse who earns a substantial salary, substantial 
investment income, or high salaries they earned themselves during 
the part of the year they were employed. 

Moreover, lower income taxpayers are often ineligible for unemploy- 
ment compensation programs because they have worked in occupa- 
tions not covered by unemployment insurance or for too short a period 
to qualify for the payments. The tax savings per recipient in 1970 
were estimated to be nearly twice as high in families with incomes 
above $25,000 as in families with incomes under $5,000. 

A recent study cited below noted that in 1970 unemployment 
benefits averaged about two-thirds of net earnings (i.e., earnings 
minus social security and other Federal, State, and local taxes). 
Benefits that are high relative to net earnings because they are 
tax exempt offer a better cushion against financial hardship during 
unemployment, but at the same time they may discourage the seeking 
of new employment. Taxation of the benefits might reduce this 
disincentive effect upon some of the recipients with substantial 
amounts of taxable income. 

(109) 



110 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

Oto 7 21. 9 

7 to 15 39. 

15 to 50 33.3 

50 and over 5. 7 

Rationale 

There is no statutory basis for this provision. The decision to exempt 
unemployment compensation benefits from income taxation was 
made administratively by the Treasury Department in a 1938 ruling. 

Selected Bibliography 

Feldstein, Martin, "Unemployment Compensation: Adverse In- 
centives and Distributional Anomalies," National Tax Journal, Vol. 
27 (June 1974), pp. 231-44. 



EXCLUSION OF WORKER'S COMPENSATION 

BENEFITS 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


640 
555 
505 




640 
555 
505 



Authorization 

Section 104(a)(1). 

Description 

Worker's compensation benefits are not taxable. 

Impact 

Similar to the sick pay exclusion, the provision reduces tax burdens 
during periods of illness. It also exempts benefits for permanent 
injuries. The benefit amounts are specified by State law (in contrast 
to the sick pay exclusion, where payments are subject to the em- 
ployer's discretion) . 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 

Adjusted gross income class (thousands of dollars) : distribution 

to 7 22. 1 

7 to 15 38.5 

15 to 50 33. 7 

50 and over 5. 8 

Rationale 

A rationale for this provision is not offered in the committee reports 
accompanying its enactment in 1918. 

Further Comment 

The level of worker's compensation is specified by law and is related 
to salary level. Minimum and maximum benefit levels apply and 
payments are based on degree of disability and may be related to 
family size, but not to the amount of other family income. If the 
benefits were made taxable, their level and structure might require 
adjustment. 

(Ill) 



112 

Selected Bibliography 

Goode, Richard. The Individual Income Tax, Rev. ed. The Brook- 
ings Institution, Washington, D.C., 1976, pp. 107-09. 

Wentz, Roy, "An Appraisal of Individual Income Tax Exclusions," 
U.S. Congress, House, Committee on Ways and Means, Tax Revision 
Compendium, 1959, pp. 329-40. 



EXCLUSION OF PUBLIC ASSISTANCE BENEFITS 



Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


130 

115 

105 


130 
115 
105 



Authorization 

No general statutory authorization. A number of revenue rulings 
under section 61 have declared specific types of public assistance 
payments excludable. 

Description 

Individuals may exclude public assistance payments from income; 
thus the payments are tax exempt. 

Impact 

Because of the level of public assistance payments and other income 
of recipients, most individuals who receive these payments would have 
no income tax liability even if the payments were taxable. Those 
who do benefit from the exclusion tend to be those who receive 
high public assistance payments or who receive public assistance 
during part of the year and are employed the remainder. There is no 
conclusive evidence that the tax treatment affects the recipients' 
incentive to work. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

to 7 93. 3 

7 to 15 6.7 

15 to 50 

50 and over 

(113) 



114 

Rationale 

Revenue rulings generally exclude government transfer payments 
from income because they are considered to be general welfare pay- 
ments. While no specific rationale has been advanced for this ex- 
clusion, the reasoning may be similar to that for social security 
payments — that they are in the nature of gifts, and that Congress did 
not intend to tax with one what it pays out with the other. 

Further Comment 

Perhaps the major question involved in the tax treatment of public 
assistance payments is whether they should be excluded from taxable 
income or whether exemptions in the tax law designed to remove 
low-income individuals from the tax rolls are sufficient. Thus, if the 
present level of exemptions reflects a general agreement on an income 
level below which taxes are not to be paid, a case might be made for 
including public assistance payments in income, just as are other 
receipts. 

Selected Bibliography 

Goode, Richard, The Individual Income Tax, Rev. ed., The Brook- 
ings Institution, Washington, D.C., 1976, pp. 100-03. 



NET EXCLUSION OF PENSION CONTRIBUTIONS 
AND EARNINGS 

Employer Plaxs 
Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


. 6, 475 
. 5, 745 
. 5, 225 




6,475 
5,745 
5, 225 



Authorization 

Sections 401-407, 410-415. 

Description 

Employer contributions to qualified pension and profit-sharing plans 
on behalf of an employee are excluded from the employee's income, but 
generally constitute currently deductible business expenses for the 
employer. Investment income of such plans (including that attribut- 
able to employer contributions) is exempt. The employee is taxed only 
on amounts which he receives (with appropriate adjustment where he 
has contributed). For this treatment to apply, the plan must be "quali- 
fied", i.e., must satisfy a number of statutory requirements including 
nondiscrimination, participation, and vesting. 

Impact 

The tax expenditure is composed of two elements: (1) the average 
employee's marginal tax rate will be lower during his retirement years 
than during his working life because of lower income and special tax 
provisions for the aged; and (2) current aggregate pension contribu- 
tions and investment income which are not taxed exceed aggregate 
amounts paid out as taxable benefits. 

Once an employee's rights to a pension become nonforfeitable, he 
enjoys a tax deferral which is the equivalent of an interest free loan. 
There are conflicting views concerning whether employers also enjoy 
tax deferral. Their deductions may be viewed as accelerated from the 
time the employee's rights become nonforfeitable to the time at which 
the contributions are made. Under this view, the employer's liability 
is to pay pensions when due, and making the contribution amounts to 
a shifting of the form of the employer's assets. On the other hand, 
it is argued that the employer's deduction is not accelerated because 

(115) 



116 

the contribution discharges a current expense, the pension cost for 
the current period. 

The employees who benefit from this provision are primarily middle 
and upper income taxpayers whose employment has been sufficiently 
continuous for them to qualify for benefits in a company or union- 
administered plan. 



Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

to 7 3. 7 

7 to 15 22. 5 

15 to 50 57. 

50 and over 16. 8 

Rationale 

This provision was adopted initially in 1921. It was apparently 
designed to encourage receptivity to employer established retirement 
programs. 

Selected Bibliography 

U.S. Congress, House Committee on Ways and Means, Panel 
Discussions. General Tax Reform, Part 7 — Profit Sharing and Deferred 
Compensation, February 22, 1973. 

"New Developments in Tax Administration and Pension Plans", 
Symposium, National Tax Journal, September 1974. 



NET EXCLUSION OF PENSION CONTRIBUTIONS 

AND EARNINGS 

Plans For Self-Employed and Others 
Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


965 
770 
390 




965 

770 
390 



Authorization 

Sections 401-405, 408-415. 

Description 

Self-employed individuals may exclude from gross income 15 
percent of their earned income or $7,500 a } r ear, whichever is less, 
for contributions to a qualified tax exempt retirement plan. 

Any employee not covered by a government pension plan or a 
qualified retirement plan ma}^ set up a tax exempt individual retire- 
ment account (IRA) with tax deductible contributions up to the 
lesser of $1,500 per year or 15% of compensation. 

Pa}mients received from either type of retirement plan are included 
in income for tax purposes. 

Impact 

These provisions, like those for emplo3 r er plans, allow deferral of 
tax liability both on the deductible contributions themselves and the 
earnings of the fund. This is equivalent to an interest-free loan. In 
addition, when the individual receives the payments from the fund, 
he is likely to be in a lower tax bracket than during his earning years 
due to the probability of reduced income and the existence of other 
tax provisions which reduce the tax liability of the elderly and retired. 

The tax benefits of self-employed plans are enjoyed more by higher 
income individuals than are those of employer plans because pro- 
fessional and other higher income self-employed individuals are more 
likely to be able to set aside the maximum contribution amounts. The 
extent to which the provision encourages more saving, rather than 
changing the form in which the wealth is held, is uncertain. 

(117) 



118 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Adjusted gross income class (thousands of dollars) : distribution 

0to7 .4 

7 to 15 3. 5 

15 to 50 51.3 

50 and over 44. 8 

Rationale 

The exclusion for self-employed individuals is intended to provide 
treatment similar to that afforded employees securing benefits under 
employers' qualified plans. This legislation was enacted in 1962. It 
was considerably liberalized in 1974 when the provision for individual 
retirement accounts (IRAs) was enacted. 

Further Comment 

Several questions continue to be raised apart from the basic issue 
of a tax exclusion for saved income: Should the dollar limitation on 
self-employed plans differ from that of the individual retirement 
accounts? Should there be dollar limitations on such plans when there 
are none on employer plans? Should those who are covered by em- 
ployer plans be allowed to deduct the difference between their em- 
ployer's contribution and the maximum limitations provided in the 
law? 

Selected Bibliography 

U.S. Congress, House, Committee on Wa}~s and Means, Panel 
Discussions. General Tax Reform, Part 7 — Pensions, Profit-sharing, 
and Deferred Compensation, February 22, 1973, pp. 913-1168. 

Schmitt, Ray, "Limitations on Private Pension Benefits and Con- 
tributions — Problems in Establishing Equitability." Library of Con- 
gress. Congressional Research Service, Multilith 75-162ED, July 11, 
1975, 62 pages. 

U.S. Congress, House, Subcommittee on Oversight of the Com- 
mittee on Ways and Means, Survey Report on Individual Retirement 
Accounts, Prepared by the Education and Public Welfare Division, 
Congressional Research Service, Library of Congress, November 17,- 
1975, 24 pages. 



EXCLUSION OF OTHER EMPLOYEE BENEFITS 

Premiums ox Group Term Life Ixsuraxce 
Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


895 
805 
740 




895 
805 
740 



Authorization 

Section 79, L.O. 1014, 2 C.B. 8 (1920). 

Description 

Employer payments of emplo}^ee group term life insurance premiums 
for coverage up to $50,000 are not included in income by the employee. 
Since life insurance proceeds are not subject to income tax, the value 
of this fringe benefit is never subject to income tax. 

Impact 

These insurance plans, in effect, provide additional income to 
employees. Since neither the value of the insurance coverage nor the 
insurance proceeds are taxable, this income can be provided at less 
cost to the employer than the gross amount of taxable wages which 
would have to be paid to employees to purchase an equal amount of 
insurance. Group term life insurance is a significant portion of total 
life insurance covering over 90 million policies and accounting for 
over 40 percent of all life insurance in force. Individuals who are 
self-emplo3 r ed or who work for an employer without a plan do not 
have the advantage of a tax subsidy for life insurance protection. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Adjusted gross income class (thousands of dollars) : distribution 

Oto 7 7.4 

7 to 15 32. 4 

15 to 50 50. 7 

50 and over 9. 6 

(119) 



120 

Rationale 

This exclusion was originally allowed, without limitation as to 
coverage, by administrative legal opinion (L.O. 1014, 2 C.B. 8 (1920)). 
The reason for the ruling is unclear, but it may have related to sup- 
posed difficulties in valuing the insurance to individual employees 
since the value is closely related to age and other mortality factors. 
Studies later indicated valuation was not a problem. The limit on the 
amount subject to exclusion was enacted in 1964. Keports accompany- 
ing that legislation reasoned that the exclusion would encourage the 
purchase of group life insurance and assist in keeping the family 
unit intact upon death of the breadwinner. 

Selected Bibliography 

The Lije Insurance Fact Book, 1975. 

U.S. Congress, House, Committee on Ways and Means, Hearings 
on President's 1963 Tax Message, February 6, 7, 8, and 18, 1963, 
pp. 108-13. 



EXCLUSION OF OTHER EMPLOYEE BENEFITS 

Premiums on Accident and Accidental Death Insurance 

Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


60 
55 
50 




60 
55 
50 



Section 106. 



Authorization 



Description 



Premiums paid by employers for employee accident and accidental 
death insurance plans are not included in the gross income of emploj^ees 
and, therefore, are not subject to tax. 

Impact 

As with term life insurance, since the value of this insurance cover- 
age is not taxable, the emplo3^er would have to pay more in wages, 
which are taxable, to confer the same benefit on the employee. Em- 
ployers thus are encouraged to buy such insurance for employees. 
Insurance awards to employees for accidents and accidental death 
are generally exempt from income tax. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 

Adjusted gross income class (thousands of dollars) : distribution 

0to7 7. 5 

7 to 15 32. 5 

15 to 50 50. 

50 and over 10. 

Rationale 

This provision was added in 1954. Previously, only payments for 
plans contracted with insurance companies could be excluded from 
gross income. The committee report indicated this provision equalized 
the treatment of employer contributions regardless of the form of the 
plan. 

(121) 



122 

Selected Bibliography 

Guttentag, Joseph F., E. Deane Leonard, and William Y. Rode- 
wald, "Federal Income Taxation of Fringe Benefits: A Specific Pro- 
posal," National Tax Journal, September 1953, pp. 250-72. 

U.S. Congress, House, Committee on Ways and Means, "An Ap- 
praisal of Individual Income Tax Exclusions" Prepared by Roy 
Wentz for the House Committee on Ways and Means, Tax Revision 
Compendium, 1959, pp. 329-40. 



EXCLUSION OF OTHER EMPLOYEE BENEFITS 

Privately Fixaxced Supplementary Unemployment 

Bexefits 



Estimated Revenue Loss 



[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


5 
5 

5 




5 
5 
5 



Section 501(c) (17). 



Authorization 



Description 



Employer payments into a qualified supplementary unemployment 
insurance benefit trust are not taxable income to the employees when 
paid into the trust, nor are the earnings of the trust fund taxable as 
they accrue. The payments into the fund are deductible as business 
expenses by the employer. Benefits paid out are taxable to employees 
only upon receipt. 

Impact 

The employer contributions and earnings thereon provide a fringe 
benefit for the employees. In effect, these contributions buy unem- 
ployment insurance coverage for each employees. As in the case of 
insurance premiums paid by employers to cover their employees, 
the employer would have to pay more in wages which would be taxable, 
to confer the same value of benefits on the emplo^'ees as he does by 
making payments into these qualified benefit trusts. 

Such plans are particularly attractive in industries affected by 
cyclical unemployment. Data collected in the mid-sixties indicated 
that these plans were concentrated primarily in the auto, steel, gar- 
ment, and rubber industries. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 
Adjusted gross income class (thousands of dollar?) : distribution 

Oto 7 20. 

7 to 15 60. 

15 to 50 20. 

50 and over 

(123) 
67-312—76 9 



124 

Rationale 

The specific exemption relating: to such plans (501(c) (17)) was 
enacted in 1960. However, such plans could also qualify for exemption 
under 501(c)(9), predecessors of which have been in the tax law 
since its inception. The 501(c) (17) exemption was made to allow the 
qualification of plans that did not otherwise qualify under section 
501(c)(9), primarily because of limitations on investment income. 

Selected Bibliography 

U.S. Department of Labor, Major Collective Bargaining Agree- 
ments — Supplemental Unemployment Benefit Plans and Wage-Employ- 
ment Guarantees, Bulletin No. 1425-3, June 1965, 108 pages. 



EXCLUSION OF OTHER EMPLOYEE BENEFITS 

Meals axd Lodging 
Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


. 305 

. 285 

265 


305 

285 
265 



Section 119. 



Authorization 



Description 



Employees exclude from income the value of meals and lodging 
furnished by the employer on his business premises and for his con- 
venience; the lodging must be required as a condition of employment. 

Impact 

Meals and lodging furnished by the employer may, in certain cases, 
constitute a very large portion of the employee's compensation (e.g., 
in the case of a live-in housekeeper or an apartment resident manager) . 
The value to the employee of such in-kind income in some cases may 
be difficult to establish. For example, the lodging may simply duplicate 
rather than substitute for private quarters. The value of the exclusion 
depends on the value of the income in-kind and the tax bracket of 
the employee. To the extent that money wages are lower as a result 
of the tax benefit, employment is subsidized in occupations which 
involve this type of income in-kind. 



Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

PeTcmJntjc 

Adjusted gross income class (thousands of dollars) : distribution 

0to7 7.4 

7 to 15 32. 

15 to 50 50. 9 

50 and over 9. 7 

(125) 



126 

Rationale 

The convenience-of-tho-employer rule has been in the tax regula- 
tions since 1918, presumably in recognition of the problems discussed 
above. Treatment of such payments was handled through regulation 
and court decisions until 1954. The regulations suggest that immedi- 
ately prior to the 1954 Act, meals and lodging that were in the nature 
of compensation (i.e., taken into account in computing salary) were 
included in income even if they were for the convenience of the 
employer. The specific statutory language was adopted to end the 
confusion regarding the tax status of such payments by precisely 
defining the conditions under which such meals and lodgings were 
taxable. 

Further Comment 

The difficult}^ in many cases in valuing these benefits is cited as a 
major argument against taxing such benefits. On the other hand, this 
argument is challenged by others who cite the fact that these payments 
are valued under the social security law and under many State welfare 
laws. 

Selected Bibliography 

Kahn, C. Harr\ r . Employee Compensation Under the Income Tax, 
National Bureau of Economic Kesearch, New York, 1968, pp. 82-7. 

Guttentag, Joseph H., E. Deane Leonard, and William Y. 
Rodewald, "Federal Income Taxation of Fringe Benefits: A Specific 
Proposal," National Tax Journal, September 1953, pp. 250-72. 



EXCLUSION OF INTEREST ON LIFE 
INSURANCE SAVINGS 



Estimated Revenue Loss 

[In millions of dollars] 
Fiscal year Individuals Corporations Total 

1977 1,855 1,855 

1976 1,695 1,695 

1975 1,545 1,545 

Authorization 

Section 101(a) and case law interpreting Treas. Reg. 1.451-2. 

Description 

Most life insurance policies, other than term policies, accumulate 
interest bearing reserves which benefit the policyholder by, in effect, 
reducing his premiums. However, this interest is not included in the 
policyholder's income for tax purposes as it accumulates. Pursuant to 
section 101 (a), polic}^ proceeds paid because of the death of the insured 
usually are not included in income. Therefore, when policy proceeds 
are not taxed at death, the previously accumulated interest is not 
taxed at all. If a policy is surrendered before death, only the exee-s 
of the cash surrender value over the premiums paid is included in 
income, with the result that the cost of the current insurance and 
initial expense charges can be offset against the interest income. 

Impact 

The effect of this exclusion allows personal insurance to be partly 
purchased with tax-free interest income. Although the interest earned 
is not currently paid to the policyholder, he may receive the interest 
payments if he terminates the policy. In the case of a surrender, the 
deferral of tax on this income is equivalent to an interest-free loan. 
Furthermore, there is usually no taxable income at death or on other 
payment of the proceeds, and thus the interest income is usuallv 
exempt from tax. 

This provision thus offers preferential treatment for the purchase of 
life insurance coverage and for savings held in life insurance policies 
Because middle income taxpa} T ers are the major purchasers of this 
insurance, they are the primary beneficiaries of the provision. Higher 
income taxpayers who are not seeking insurance protection, can 
obtain comparable, it not better, yields from tax-exempt State and 
local obligations. 

(127) 



128 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

to 7 11.3 

7 to 15 . 22. ."» 

1.") to 50 41. 5 

50 and over 24. 6 

Rationale 

The exclusion of death benefits dates back to the 1913 tax law. 
While no specific reason was given for exempting such benefits, 
insurance proceeds may have been excluded because they are com- 
parable to bequests which also were excluded from the tax base. 

The nontaxable status of the interest as it accumulates is based 
upon the general tax principle of "constructive receipt", i.e., that 
income is only taxable to a cash basis taxpayer when it i- received by, 
or readily available to, him. The interest income is not viewed as 
readily available to the policyholder because he must give up the 
insurance protection by surrendering the policy in order to obtain the 
interest. 

Further Comment 

Although significant practical, social, and legal questions would be 
involved, the interest component could be taxed as earned or could be 
taxed when the proceeds are paid. Taxing the interest element when 
the proceeds are paid would still defer tax for the period from when it 
is earned until the time the proceeds are paid. 

Selected Bibliography 

Goode, Richard. The Individual Income Tax, Rev. ed., The Brook- 
ings Institution, Washington, D.C., 1976, pp. 125-33. 

McLure, Charles E., "The Income Tax Treatment of Interest 

Earned on Savings in Life Insurance," in U.S. Congress, Joint Eco- 
nomic Committee, The Economics oj Federal Subsidy Programs, 
Part 3— Tax Subsidies, July 15, 1972, pp. 370-405. 



EXCLUSION OF CAPITAL GAINS ON HOUSE 
SALES IF OVER 65 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

197.') 


50 

4.') 
40 




50 

4:> 
40 



Section 121. 



Authorization 



Description 



An individual who has reached 65 years of age may exclude from 
taxable income some or all of the gain realized from selling the house 
u<ed as his principal residence for at least 5 of the 8 years before the 
sale. 

If the residence is sold for $20,000 or less, none of the gam is taxable. 
If the residence is sold for more than $20,000, only a part of the gain — 
calculated by multiplying the gain by the ratio of $20,000 to the sales 
price — is not taxed. 

The provision can be used only once dv a taxpayer. 

Example 

A residence that cost $30,000 is sold for $40,000. The $10,000 gain is 
multiplied by £20,000/840,000 so $5,000 is excluded from tax. Sim- 
ilarly, if the same residence were sold for $60,000, one-third ($20,000/ 
$60,000) of the $30,000 gain, or $10,000, would be excluded. 

Impact 

This provision benefits elderly persons who sell their home- and do 
not purchase replacement homes. The benefits of this provision are 
more concentrated among higher income taxpayers than are some other 
provisions benefiting the aged (such as social security and the retire- 
ment income credit). Other things being equal, there is an incentive 
for the homeowner to wait until age 65 before selling the house. Viewed 
in conjunction with section 1034 (which permits deferral of tax on 
gain realized upon the sale of a residence when a more expensive resi- 
dence is purchased within IS months), section 121 allows a permanent 
exemption of some or all of the gain realized on prior home sales 
which met the requirements of section 1034. 

(129) 



130 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Adjusted gross income class (thousands of dollars) : distribution 

to 7 10. 

7 to 15___ 20. 

15 to 50 30. 

50 and over 40. 

Rationale 

This provision was added to the tax law in 1964 to provide relief 
for elderly taxpayers who sell their houses to rent apartments or 
make other living arrangements. The committee report noted that 
section 1034 (see p. 73) often did not help the elderly who desired to 
purchase a smaller house or rent an apartment. 

Further Comment 

Most of the legislative proposals regarding this provision would 
raise the $20,000 ceiling to reflect the impact of inflation, or extend 
the exclusion to all taxpayeis regardless of age. 

Selected Bibliography 

U.S., Congress, House, Committee on Ways and Means, Panel 
Discussions. General Tax Reform, Part 2— -Capital Gains and Losses 
(note, particularly, testimony of Kenneth B. Sanden, p. 254). 



DEDUCTIBILITY OF CASUALTY LOSSES 

Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


330 
300 
280 




330 
300 
280 



Section 165(c)(3). 



Authorization 



Description 



To the extent it exceeds $100, the uninsured portion of losses 
attributable to theft, fire, storm shipwreck, or other casualty, may be 
deducted from adjusted gross income. 

Impact 

This provision grants some financial assistance to those who suffer 
casualties, have tax liability, and itemize deductions. It shifts part of 
the loss from the property owner to the general taxpayer and thus 
serves as a form of insurance. The same dollar amount of loss has a 
proportionately greater effect on a low-income family than on a higher 
income family, yet the insurance feature of the deduction is greater 
for taxpayers in higher income tax brackets. 



Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

to 7 2.7 

7 to 15 28.2 

15 to 50 45. 5 

50 and over 23. 5 

Rationale 

The deduction for casualty losses was allowed under the original 
1913 income tax law without distinction between business-related 
and nonbusiness-related losses. No rationale was offered then. In 
1964, the $100 floor on the deduction was enacted, and the purpose 
of relieving hardship was articulated in the legislative history. 

(131) 



132 

Further Comments 

Several proposals to limit the casualty loss deduction have been 
made. The most common proposal would permit a deduction for only 
as much of the loss as exceeds 3 percent of adjusted gross income. 
Proposals of this nature have been 7nr.de at various times by the 
Treasury Department, members of the Ways and Means Committee, 
and others. This approach would continue relief for very large losses (in 
relation to income) but would remove the deduction for relatively 
smaller Losses. 

Selected Bibliography 

Kahn, C. Harry. Personal Deductions in the Federal Income Tax, 
Princeton, Princeton University Press, 1960, pp. 1-8 and 156-61. 

Goode, Eichard. The Individual Income Tax, Rev. ed., the Brook- 
ings Institution, Washington, D.C., 1976, pp. 153-55. 



EXCESS OF PERCENTAGE STANDARD 
DEDUCTION OVER LOW INCOME ALLOWANCE 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


1, 560 
1, 465 
1, 385 




1, 560 
1. 465 
1, 385 



Section 141. 



Authorization 
Description 



Taxpayers who do not itemize deductions may claim the standard 
deduction, which is calculated as a percentage of adjusted gross 
income (AGI), subject to both a maximum and a minimum dollar 
amount. The minimum amount is commonly referred to as the low 
income allowance. 

Before temporary changes were made in 1975, the percentage stand- 
ard deduction was 15 percent of AGI up to $2,000 (SI, 000 for married 
poisons filing separately), and the low-income allowance was $1,300 
($650 for married persons filing a separate return). These limits will 
be reinstated in 1977 if the present temporary limits are not continued. 

The Tax Reduction Act of 1975 increased the percentage standard 
deduction to 16 percent of AGI up to $2,300 for single returns, $2,600 
for married persons filing joint returns and 81,300 for married persons 
filing separate returns. The low-income allowance was increased for 
these taxpayers to $1,900, $1,600 and $950 respectively. These amounts 
apply to 1975 tax returns. 

The Revenue Adjustment Act of 1975 increased the standard 
deduction for 1976 only to 16 percent of AGI subject to a maximum 
of $2,200 for single persons, $2,400 for married persons filing joint 
returns, and $1,200 for married persons who file separately. The pur- 
pose of the act is to effect a 6-month tax cut based on annual maxi- 
mums of $2,400, $2,800, and $1,400 respectively; if the cut is extended 
for a full year, these latter amounts will be the statutory limits. 

Similarly, the low-income allowance for 1976 returns now is $1,500 
for single persons, $1,700 for married persons filing jointly, and $850 
for married persons filing separatelv; if the cuts are extended for a 
full year, the amounts would be $1,700, $2,100, and $1,050 respectively. 

(133) 



134 

Impact 

The minimum standard deduction was first adopted in 1964 and 
was expanded and renamed the low income allowance in 1969. The 
tota] of the low-income allowance and the personal exemptions has 
roughly corresponded to the poverty income level. The amount is 
viewed as a floor below which income should not be taxed. The 
standard (deduction is granted in lien of all so-called itemized deduc- 
tions (see Appendix A). To the extent it exceeds the comparable 
low income allowance, it is a tax expenditure since it substitutes for 
a scries of individual itemized deductions that are tax expenditures. 
A low-income allowance of $1,700 and $2,100 for single and joint 
return- respectively exceeds the percentage standard deduction if 
AGI is not greater than $10,625 and $13,125 respectively. The tax 
expenditure thus is limited to those with AGI levels above tl 
amounts. 

Until recent years, the standard deduction was chosen by nearly 
all persons who did not own their own homes and could not deduct 
mortgage interest and property taxes. With the rise in State and local 
taxes, a -lightly larger group finds itemizing more advantageous than 
the standard deduction. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class x 

Adjusted gross income class (thousands of dollars) : didriimtiou 

to 7 1. 1 

7 to 15 56. 3 

15 to 50 42. 1 

50 and over . (j 

1 The distribution table reflects tax law in 1974. 

Rationale 

The standard deduction was introduced into the income tax struc- 
ture in 1944. At that time the amount allowed was 10 percent of AGI 
up to a maximum of 8500. The minimum standard deduction was 
introduced in 1964 and replaced by the low-income allowance in 1969. 
The original objective of the standard deduction was to simplify the 
tax structure by eliminating the need to itemize personal deductions. 
The low-income allowance was designed to remove poverty level 
families from the tax rolls. 

Selected Bibliography 

Goodc, Richard. The Individual Income Tax, Rev. ed. the Brook- 
ings Institution, Washington, D.C., 1976, pp. 216-21. 

Kahn, C. Hany Personal Deductions in the Federal Income Tax, 
Princeton, Princeton University Press, 1960, pp. 162-72. 



ADDITIONAL EXEMPTION FOR THE BLIND 

Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


25 
20 
20 




25 
20 
20 



Section 151(d). 



Authorization 



Description 



Blind taxpayers receive a special exemption of $750 in addition to 
the normal personal exemption. The extra exemption is not available 
for blind dependents. 

Impact 

The benefits accrue to taxpayers who are blind or have a blind 
spouse. Because of their disability, blind persons may incur extra 
expenses to live at a given standard, and the extra exemption helps 
compensate for this. The amount of tax relief per exemption increases 
from $105 to $525 as the marginal tax rate increases from 14 to 70 
percent. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Adjusted gross income class (thousands of dollars) : distribution 

0to7 26.7 

7 to 15 40. 

15 to 50 26. 7 

50 and over 6. 7 

Rationale 

Special tax treatment for the blind first appeared in 1943 when 
additional benefits were available through an itemized deduction. The 
law was amended in 1948 to offer relief as an exemption so that all 
blind taxpayers could claim the allowance. 

(135) 



67-312—76 10 



136 

Further Comment 

Taxpayers with other disabilities such as deafness or paralysis 
do not receive comparable benefits, nor do nontaxpayers who are blind. 
Either direct spending assistance for the handicapped or a refundable 
credit that would be phased down for taxpayers at higher income 
levels would be more oriented toward the low-income blind than is 
the present provision. Note that the Supplemental Security Income 
Program provides direct income support to low-income blind persons, 
and that blind persons also may be covered under the disability 
provisions of social security. 

Selected Bibliography 

Goode, Richard. The Individual Income Tax. Rev. ed. Washington, 
D.C., The Brookings Institution, 1976, pp. 222-23. 

Selzer, Lawrence H. The Personal Exemption in the Income Tax. 
New York, National Bureau of Economic Research, 196S, pp. 113-20. 

Groves, Harold M. Federal Tax Treatment oj the Family. Washing- 
ton, D.C., The Brookings Institution, 1963, pp. 54-55. 



ADDITIONAL EXEMPTION FOR OVER 65 



Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


. 1,220 

1,155 

1,100 


1,220 
1, 155 
1, 100 



Section 151(c). 



Authorization 



Description 



An additional personal exemption of $750 is allowed for a taxpayer 
who is 65 or older. 

Impact 

The amount of tax relief per exemption increases from $105 to 
$525 as the marginal tax rate increases from 14 to 70 percent. This 
provision offers no assistance to elderly persons who have no tax 
liability. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

0to7 25.0 

7 to 15 40. 3 

15 to 50 27.6 

50 and over 7. 1 

Rationale 

The additional personal exemption originally was provided in the 
Revenue Act of 1948 to provide tax relief for the elderly whose 
income sources were reduced by old age. 

Further Comment 

The present additional exemption should be viewed within the 
context of the total transfer pa3mient program currently in force, 
parts of which only provide cash payments to needy elderly persons. 
See the comment under the exclusion for social security benefits, 
page 104. 

(137) 



138 

Selected Bibliography 

Groves, Harold M. Federal Tax Treatment of the Family. Washington, 
D.C.: The Brookings Institution, 1963, pp. 52-^4. 

Seltzer, Lawrence, H. The Personal Exemption in the Income Tax. 
New York, National Bureau of Economic Research, 1968, pp. 113-20. 



RETIREMENT INCOME CREDIT 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


110 
120 
130 




110 
120 
130 



Section 37. 



Authorization 



Description 



Subject to limitations, individuals are allowed a tax credit equal to 
15 percent of their retirement income. For those under 65, retire- 
ment income includes only the taxable portion of public retirement 
benefits. For those 65 or over, pensions, annuities, certain bond and 
other interest, gross rents, and dividends are defined as retirement 
income. In order to qualify, an individual must have earned at least 
$600 or more in each of any 10 previous years. 

Retirement income eligible for the credit is limited to $1,524 for 
an individual; however, married taxpayers may take a credit on as 
much as $2,286 if either meets the tests for qualification as long as 
both are 65 or over. Thus, the maximum credit per person is $229 
(15 percent of $1,524). 

For those under 62, retirement income must be reduced by all 
earned income over $900. For those over 62 but under 72, retirement 
income must be reduced by one-half of earnings over $1,200 and under 
$1,700 and by all earnings over $1,700. For those over 72, retirement 
income is not reduced by earned income. However, for all income 
groups, retirement income must also be reduced by tax exempt pen- 
sions or annuities, such as social security benefits. 

Example 

x- hi ^band and wife are both 66 and file a joint return. He meets 
the i J-year prior earned income test, but she does not. He receives a 
taxable pension of $4,000, wages of $1,300 for part-time work, and a 
social security pension of $800. She receives a social security pension 

(139) 



140 

of $400 and wages of $1,800. Under the joint method, the retirement 
income is $686, determined as follows: 

Maximum amount upon which credit may be based $2, 286 

Less: 

Husband's social security pension 800 

Wife's social security pension 400 

One-half of husband's wages over $1,200 but not over $1,700 50 

One-half of wife's wages over $1,200 but not over $1,700 250 

Wife's wages over $1,700 100 

Total 1, G00 

Retirement income G86 

The retirement income credit under the joint method is $102.90 
($686X15 percent). 

Impact 

Because the amount of eligible income is reduced by the amount of 
social security benefits received, the primary beneficiaries of this 
provision are Federal and some State and local government retirees 
who do not receive social securit}^ benefits. Because the provision is 
a credit, its value to the taxpayer is affected only by the level of 
benefits and not by the tax bracket of the recipient. Nevertheless, 
the benefits from the credit are slightly less concentrated in the lower 
range of the income scale than the tax relief from the exclusion of 
social security benefits. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

0to7 41.0 

7 to 15 39.0 

15 to 50 19.0 

50 and over 1. 

Rationale 

The retirement income credit was enacted in 1954. It was intended 
to remove inequities between individuals who received pensions and 
other forms of retirement income that were not tax exempt and 
recipients of social security, which is tax exempt. At that time many 
features of the credit were closely related to the social security benefit 
system (for example, the maximum eligible retirement income and the 
earnings test). The provision was amended in 1956, 1962, and 1964 to 
reflect changes in social security; however, no change has been made 
in the maximum amount eligible for the tax credit since 1962, even 
though social security benefits have increased substantial^ since then. 

Further Comment 

Substantial criticism of the retirement income credit has developed 
because its complexity has deterred mam^ taxpayers from using it 
and because it has not kept pace with changes in social security 
payments. 



141 

Two substantially different proposals have been advanced in 
response to these criticisms. One would revise the credit to reflect 
changes in levels of benefits and other social security features, thus 
reorienting the retirement credit more toward its original purpose. 
Another approach, reflecting concern about the complexity of the 
provision, would make it available to all taxpayers age 65 or over 
without any restrictions on earnings. However, this alternative 
would continue to reduce the base for computing the credit by the 
amount of any social security or other tax exempt pension income. 
H.R. 10612, passed by the House in December 1975, adopted this 
latter general approach. 

Selected Bibliography 

U.S. Congress, House, Committee on Ways and Means, Retire- 
ment Income Credit, Child Care Deduction, Qualified Stock Options, and 
Sick Pay Exclusion. Prepared by the staff of the Joint Committee on 
Internal Revenue Taxation, September 22, 1975, pp. 1-4. 



EARNED INCOME CREDIT 

Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


1 1, 390 
1 1, 455 




1 1, 390 
1 1, 455 



1 The estimated revenue loss reflects cash refunds of the credit as well as reductions of 
tax liability. OMB includes the refundable amount in direct outlays in the budget, and not 
as a tax expenditure. The cash refunds for 1976 are estimated at $1,165 million, and those 
for 1977 are estimated at $1,110 million. 

Authorization 

Section 43. 

Description 

This tax credit is available only to low-income workers who have 
dependent children and maintain a household. The maximum credit 
is 10 percent of the first $4,000 of earned income. The credit is reduced 
by 10 percent of the taxpayer's adjusted gross income (AGI) (or 
earned income if greater) above $4,000 so that it becomes zero at 
AGI of $8,000. 

The credit is subtracted from tax liability, if any. As contrasted with 
all previously enacted tax credits, credits in excess of tax liability are 
paid in cash to the eligible worker. 

The Revenue Adjustment Act of 1975 in effect extended this 
provision at its previous level to June 30, 1976 ; otherwise it would have 
expired on December 31, 1975. The extension technically specifies a 
5-percent credit for income earned in 1976, which would be increased 
to 10 percent if the provision is fully extended through December 31, 
1976. 

Impact 

The earned income credit may be viewed as a partial offset to 
social security taxes on low-income workers. The combined employer- 
employee social security tax rate is 11.7 percent (5.85 percent paid by 
each party). Assuming the employee bears the burden of the em- 
ployer's portion in the form of lower wages, the 10-percent credit 
offsets 85 percent of the tax. 

The credit may help to encourage low-income workers to obtain 
employment and, thus, reduce the demand for welfare and unemploy- 
ment benefits. However, it has been argued that many of those most 
in need of relief may fail to file the tax return necessary to claim the 
credit. 

(143) 



144 

Rationale 

The earned income credit originated in the Tax Reduction Act of 
1975. Providing relief from social security taxes for low-income workers 
was one purpose. Other reasons cited by the Ways and Means Com- 
mittee include providing relief to low-income people for recent 
increases in food and fuel prices. Some opponents believe relief of this 
nature would be more efficiently administered as a reduction of social 
security tax payments made by low-income wage earner-. 

Selected Bibliography 

U.S. Congress, Senate, Committee on Finance, Tax Reduction Act 
of 1975 — Report oj the Committee on Finance together with Supple- 
mental Views on H.R. 2166, 94th Congress, 1st Session, Report No. 
94-36, March 17, 1975. 

John A. Brittam. "Social Security Taxes: Problems and Prospects 
for Reform Revisited." Tax Notes, Washington, D.C. Tax Analysts 
and Advocates, February 9. 1976, pp. 18-25. 



MAXIMUM TAX ON EARNED INCOME 

Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


580 
480 
400 




580 
480 
400 



Section 1348. 



Authorization 



Description 



Although marginal tax rates rise to 70 percent, the marginal rate 
on earned taxable income is limited to 50 percent. The amount of 
income eligible for this maximum tax provision is computed in several 
steps as follows : 

(1) Earned income that represents compensation for personal 
services, is reduced by the amount of expense connected with earning 
it. The remainder is earned net income. (2) The ratio of earned net 
income to adjusted gross income is then multiplied by total taxable 
income. The result is taxable earned income. (3) This amount is then 
reduced by certain tax preference income such as capital gains. 
(4) The result is the amount eligible for the maximum tax on earned 
income. 

The tax rate on other income is not affected. 

The maximum tax alternative cannot be used by taxpayers who 
average income and may not be used by married individuals filing 
separate returns. 

Impact 

This provision reduces the tax rate on high levels of earned income. 
However, because of the offset for tax preference income, the tax 
benefit is affected not only by the taxpayer's level of earned income 
but the extent of his preference income. Each dollar of preference 
income removes (i.e., offsets) a dollar of earned taxable income other- 
wise eligible for the maximum tax, and taxpayers with very large 
amounts of preference income may not benefit much from the provi- 
sion. Thus, the offset acts as a tax on preference income. 

Virtually all the tax savings resulting from this preferential rate 
accrue to taxpayers with $50,000 and over of adjusted gross income. 1 



1 No estimate of the income distribution of this provision was done by the Treasury 
Department for Senator Mondale. 

(145) 



146 

Rationale 

The maximum tax on earned income was adopted in 1969. Its pur- 
pose, as indicated in the Ways and Means Committee report, was to 
discourage the use of other tax reducing provisions rather than to 
provide tax relief. It was argued that a major motivation for tax 
avoidance was to protect earned income from high tax rates. The 
Senate Finance Committee, in deleting the amendment, questioned 
whether it was appropriate to reduce tax rates on earned income while 
still imposing high tax rates on other income, particularly when the 
taxpayer could use other devices to avoid high taxes on this other 
income and use the 50-percent maximum tax provision as well. The 
reduction for preference income, not originally in the House bill, was 
added in Conference presumably to respond to these objections. 

Selected Bibliography 

Sunley, Emil M., Jr., "The Maximum Tax on Earned Income, " 
National Tax Journal, December 1974, pp. 543-567. 



VETERANS' BENEFITS AND SERVICES 

(1) Exclusion of Veterans' Disability Compensation 

(2) Exclusion of Veterans' Pensions 

(3) Exclusion of GrI Bill Benefits 

Estimated Revenue Loss 

[In millions of dollars] 





Individuals 










Vet- 










erans' 










Fiscal 


dis- 


Vet- 


GI 


Corpora- 


Total 


year 


ability 


erans' 


bill 


tions 






com- 


pen- 


bene- 








pensa- 


sions 


fits 








tion 










1977___ 


595 


30 


280 




905 


1976___ 


590 


30 


330 




950 


1975 __. 


540 


25 


255 




820 



Authorization 

38 U.S.C. 3101. 

Description 

All benefits administered by the Veterans Administration are ex- 
empt from income tax. These include veterans' disability compensa- 
tion, veterans' pension payments, and educational payments. 

Impact 

Veterans' service-connected disability compensation payments are 
related not to income levels, but to the average impairment of earnings 
capacity in civil occupations resulting from the various injuries. 

The pensions paid to qualifying nonservice-disabled and aged vet- 
erans are based on "countable" income. Reaching age 65 or older is 
considered a de facto disability. The larger a veterans' countable 
income is, the smaller his pension will be. Countable income excludes 
various items, the most significant of which is the earnings of a spouse. 
Therefore, veterans with the same pension — based on the same 
countable income — can have quite different amounts of total income 
when the excluded items are taken into account. 

Veterans' educational benefits vary with the number of dependents 
and type of training. 

Based upon the foregoing criteria, beneficiaries of all three major 
veterans' programs to varying degrees may have amounts of taxable 
income in addition to their tax exempt veterans' benefits. Thus, the 
value of tax exemption of these veterans' benefits increases with the 
marginal tax bracket of the recipients. 

(147) 



148 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 





Percentage distributions 




Adjusted gross income class 


Veterans' 
disability 
pensions 


Veterans' 
pensions 


Gl bill 

benefits 


to $7,000 


29.7 


0) 

8 


75.2 


$7,000 to $15,000. 


34.8 


17.6 


$15,000 to $50,000 


32.8 


6.6 


$50,000 and over 


2.7 


.7 



i The percentage distributicn for veterans' pensions is not shown because the available data are inadequate to sup- 
port the calculation. However, the data which are available indicate the beneficiaries are largely within the to $7,000 
AGI class. 

Rationale 

Since 1917, veterans benefits have been exempt from income tax. 
The original rationale for the exemption is not clear. 

Further Comment 

One general issue concerning these benefit programs which has been 
the subject of discussion is whether net (after tax) benefit differentials 
should depend on the tax bracket of the recipient. Increases in the 
amount of direct payments under the programs are alternatives to the 
current exemptions. 

Selected Bibliography 

Goode, Kichard. The Individual Income Tax. Rev. ed. Washington, 
D.C.: The Brookings Institution, 1976, pp. 100-03. 



CREDITS AND DEDUCTIONS FOR POLITICAL 
CONTRIBUTIONS 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


65 
40 

40 




65 
40 
40 



Sections 41 and 218. 



Authorization 



Description 



AJtaxpayer is allowed a tax credit equal to one-half of his political 
contributions to candidates for Federal, State, or local office and to 
national political parties. The credit cannot exceed $25 for a single 
individual or $50 for a married couple. 

In lieu of the credit, a taxpayer may elect to take an itemized deduc- 
tion not to exceed $100 for a single individual or $200 for a married 
couple. 

Impact 

The credit allows a taxpayer to reduce the cost of a limited amount of 
political contributions b} T 50 percent, i.e., for each $2 of contribution — 
up to the limit of $50 per taxpa}^er — the Federal Government returns 
a dollar to the taxpayer in effect matching the taxpayer's contribution. 
The deduction option is preferable for taxpayers whose income is above 
the 50-percent bracket. For example, at the maximum rate of 70 per- 
cent, the taxpayer's net cost of the first $100 of contributions is $30; 
i.e., the Government matches the $30 contribution with a $70 con- 
tribution. Because of the dollar limitations, this provision is obviously 
not of great significance to large contributors. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

Oto 7 10. 

7to 15 30. 

15 to 50 50. 

50 and over 10. 

(149) 



150 

Rationale 

The credit and deduction for political contributions were adopted 
with half the current limits as part of the Revenue Act of 1971 and 
the maximum amounts were increased in 1974. Their purpose was to 
encourage more widespread financing of political campaigns through 
small contributions. 

Selected Bibliography 

U.S. Congress, The Joint Committee on Internal Revenue Taxa- 
tion, General Explanation of the Revenue Act of 1971, H.R. 10947, 
92d Congress, Public Law 92-178, December 15, 1972. 



EXCLUSION OF INTEREST ON STATE AND 
LOCAL BOND DEBT 



Estimated Revenue Loss 





[In millions of dollars] 




Fiscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


1, 390 3, 150 
1, 280 2, 890 
1, 130 2, 675 


4,540 
4, 170 
3,805 



Section 103. 



Authorization 



Description 



Interest on the obligations of State and local governments (in- 
cluding, in certain circumstances, "industrial development bonds" *) 
is excluded from gross income. 

Impact 

Because the interest is exempt from tax, the interest rate on State 
and local government obligations is lower than the rate on comparable 
taxable bonds. In effect, the Federal Government subsidizes States 
and localities by paying part of their interest cost. For example, if 
the market rate on tax exempt bonds is 7 percent when the taxable 
rate is 10 percent, there is a 3 percentage point subsidy to State and 
local governments. 

Tax exempt bonds are viewed by some persons as a particularly 
attractive form of indirect Federal aid because it operates auto- 
matically without Federal regulation. 

The tax exempt bond provision is estimated to cost the Treasury 
approximately $1 to deliver $.75 in aid to municipal governments 
through this means. It is estimated that in fiscal year 1976, $4.8 
billion in Federal revenue was foregone to save State and local gov- 
ernments about $3.6 billion in interest costs. The estimated difference 
of $1.2 billion is tax relief to investors. 

Commercial banks and high income individuals are the major 
buyers of tax exempt bonds. Of the $207 billion in outstanding munici- 
pal debt (more than double the $93 billion in 1964), about 50 percent 
is held by commercial banks and 30 percent by individuals. One study 

1 Industrial development bonds (IDBs) are obligations issued by State and local govern- 
ments, the proceeds of which are used to purchase industrial plants or equipment. These 
in turn generally are leased or sold to private firms who in effect pay the interest costs 
incurred by the State or local governments in issuing the IDBs. Interest on IDBs is taxable 
except for certain small issues and issues to finance investments in certain exempt facilities 
including principally those for air and water pollution control. 

(151) 

67-312—76—11 



152 

indicated that the tax exemption reduced the tax rate of commercial 
banks by an average of 19 percentage points. 

Tax exempt institutions, such as pension funds, have little incentive 
to invest in tax-free bonds since the return is much lower than that 
of other taxable securities. Therefore, the tax exempt nature of State 
and local debt, in effect, restricts the potential market for these 
securities. 

Commercial banks generally do not consider such bonds as priority 
items and leave the tax exempt market when money is tight. Tax 
exempt financing thus is very sensitive to changes in monetary policy. 

This tax expenditure subsidizes interest on debt that generally 
finances capital expenditures such as buildings. Thus, such projects 
are encouraged in preference to other expenditures that are not fi- 
nanced by debt. Exempt industrial development bonds finance corporate 
investments such as pollution control facilities. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 1 

Percentage 
Adjusted gross income class (thousands of dollars) : distribution 

to 7 0. 

7 to 15 . 5 

15 to 50 11. 3 

50 and over 88. 2 

1 The distribution refers to the individual tax expenditure only. The corporate tax expend- 
iture resulting from these tax provisions is not reflected in this distribution table. 

Rationale 

This exemption has been in the income tax law since 1913 and 
apparently was based on the belief that the Federal Government could 
not constitutionally tax such interest (e.g., the 1895 Supreme Court 
decision in Pollack v. Farmers' Loan & Trust Company). Today this 
view is no longer as widely held, and the continued exemption is 
justified principally as a means of assisting State and local govern- 
ments with a minimum of Federal interference. 

Further Comment 

Some projections indicate that tax exempt bonds will become some- 
what less important as a means of financing State and local capital 
expenditures because debt-financed programs (such as schools and 
roads) are growing less rapidly than programs receiving direct Federal 
support (such as sewers and water resource projects). Industrial 
development bonds for pollution control may become a major vehicle 
of tax exempt financing; these bonds would then compete with general 
purpose municipal bonds. 

Two options are frequently mentioned as alternatives or supple- 
ments to the exclusion. The first would give States and localities the 
choice of issuing either taxable or tax exempt bonds. A Federal subsidy 
then would be provided to those issuing taxable bonds to compensate 
them for the higher interest cost that would be incurred. This option 
would, among other results, help expand the municipal bond market. 
The second option would create a Federally financed development bank 
that would raise funds by selling taxable bonds at market interest 



153 

rates, and then lend to States and localities at lower interest rates. Un- 
der most initial projections, both options would result in substantial 
increased long term net outlays b} r the Federal Government because 
the direct subsidy payments are expected to exceed the increased 
income taxes paid by the recipients of the taxable securities. 

Selected Bibliography 

Bedford, Margaret E., "Income Taxation of Commercial Banks," 
Federal Reserve Bank of Kansas City, July- August 1975, pp. 3-11. 

Galper, Harvey and John Peterson, "Analysis of Subsidy Plans to 
Support State and Local Borrowing," National Tax Journal, Vol. 25 
(June 1971). 

Huefner, Robert P. Taxable Alternative Municipal Bonds, Federal 
Reserve Bank of Boston Research Report Xo. 53, 1973. 

Fortune, Peter, "Tax Exemption of State and Local Interest 
Payments: An Economic Analysis of the Issues and an Alternative," 
New England Economic Review, May/June, 1973, pp. 3-31. 

Surrey, Stanley S. Pathways to Tax Reform, Harvard University 
Press, Cambridge, Massachusetts, 1973, pp. 210-22. 

"The Tax Exemption on State and Local Bonds, A Report to the 
House Budget Committee," U.S. Congressional Budget Office, 
(November 18, 1975). 



EXCLUSION OF INCOME EARNED IN U.S. 
POSSESSIONS 

Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals Corporations 


Total 


1977 

1976 

1975 


285 

240 

245 


285 
240 
245 


Sections 931-934. 


Authorization 
Description 





A U.S. corporation engaged in the active conduct of a trade or 
business within a U.S. possession is taxable only on its U.S. -source 
income if at least 50 percent of its gross income for the last 3 years is 
from that trade or business and if at least 80 percent of its gross income 
during the same 3-year period had its source in a U.S. possession. 
Without these provisions, the corporation would be subject to U.S. tax 
on its worldwide income, and would be allowed to credit against this 
liability the income taxes it paid to the possessions and foreign 
governments. 

This exclusion applies to corporations conducting business in the 
Commonwealth of Puerto Rico and all possessions of the United 
States (mainly Guam, the Canal Zone, and Wake Island) except the 
Virgin Islands. The exclusion also applies to business operations of 
individuals in some possessions, but not in Guam, and only in Puerto 
Rico and the Virgin Islands if the individuals reside there. 

Impact 

The bulk of income earned in U.S. possessions is derived from Puerto 
Rico. Corporations operating in Puerto Rico account for about 99 
percent of the estimated revenue loss from these provisions. 

Puerto Rico grants substantial tax holidays (i.e. multi-year tax-free 
periods) to encourage corporations to engage in manufacturing opera- 
tions in the Commonwealth. Most "possessions corporations" are sub- 
sidiaries of U.S. corporations with United States (and sometimes 
foreign) operations. Often, instead of paying dividends, which would 
be taxable to the parent company, a possessions corporation is liqui- 
dated — free of U.S. tax — into the corporate parent. Both United 
States and Puerto Rican tax is avoided completely if such liquidation 
occurs at the end of a Puerto Rican tax holiday. 

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156 

Securities and Exchange Commission data indicate that drug cor- 
porations, in particular, make substantial use of this provision. For 
example, data on five drug firms indicate the income qualifying for 
this exclusion ranged from 9 percent to 21 percent of pre-tax profits. 

Rationale 

This exclusion was established in 1921. Floor debate indicates it 
was intended to encourage export trade (especially to South America) 
by improving the competitive position of U.S. companies in foreign 
markets. It is now justified as necessary to assist the economic growth 
of Puerto Rico. The present justification for this provision raises the 
same issues as the exclusion for State and local bonds, i.e. how efficient 
is the exemption and what is the distribution of benefits? 

Further Comment 

H.R. 10612 (passed by the House in 1975) would make relatively 
minor changes with respect to the annual revenue loss from this 
provision. 

Selected Bibliography 

U.S. Congress, House, Committee on Ways and Means, Energy 
Tax and Individual Relief Act of 1974- Report to accompany H.R. 
17488, No. 93-1502, November 26, 1974, pp. 168-73. 

U.S. Congress, House, Committee on Ways and Means, General 
Tax Reform, Panel Discussions, 93rd Congress, 1st Session, Part II — 
Tax Treatment of Foreign Income, February 28, 1973, pp. 1671-88. 









DEDUCTIBILITY OF NONBUSINESS STATE AND 
LOCAL TAXES (Other Than on Owner-Occupied 
Homes and Gasoline) 



Estimated Revenue Loss 

[In millions of dollars] 



Fiscal year 


Individuals 


Corporations 


Total 


1977 

1976 

1975 


6,680 
6, 505 
8,490 




6,680 
6, 505 
8,490 



Section 164. 



Authorization 



Description 



An individual can claim certain State and municipal sales, income, 
and personal property tax payments as itemized deductions. 

Impact 

This deduction for State and local tax payments benefits only tax- 
payers who itemize their deductions. They are concentrated in the 
middle and higher income brackets, largely among persons who own 
homes, because these are the taxpayers who generally itemize. 

The Federal tax deduction for State and local sales taxes and mis- 
cellaneous taxes accentuates the generally regressive nature of these 
taxes, because the amount of tax benefit per dollar of deduction in- 
creases with the tax bracket of the taxpayer. State and local income 
taxes generally are progressive, but the Federal deduction lessens the 
effect of their progressivity. 

Estimated Distribution of Individual Income Tax Expenditure by 
Adjusted Gross Income Class 

Percentage 

Adjusted gross income class (thousands of dollars) : distribution 

to 7 1. 

7 to 15 12. 9 

15 to 50 57. 3 

50 and over 28. 8 

Rationale 

The allowance of a deduction for taxes in general has always been 
a part of the income tax structure including the Civil War income 
tax. Although the legislative history is not explicit, it suggests that 

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158 

taxes were viewed as reducing net income. Some now regard this 
treatment as a form of revenue sharing. As with many other deduc- 
tions, no distinction was made between business and nonbusiness 
taxes. The deduction for the Federal income tax was eliminated in 
1917 and, for Federal excise taxes, in 1943. The deduction was elim- 
inated for State and local taxes on tobacco and alcoholic beverages 
in 1964, along with automobile and drivers' licenses and other State 
and local selective excise taxes except gasoline taxes. 

Selected Bibliography 

Goode, Richard. The Individual Income Tax, Rev. ed., Washington, 
D.C., The Brookings Institution, 1976, pp. 168-71. 

Kahn, C. Harry, Personal Deductions in the Federal Income Tax, 
Princeton, Princeton University Press, 1960, pp. 92-108. 

Moscovitch, Edward, "State Graduated Income Taxes — A State 
Initiated Form of Federal Revenue Sharing," National Tax Journal, 
March 1972, pp. 53-64. 



Appendix A 
FORMS OF TAX EXPENDITURES 



Exclusions, Exemptions, Deductions, Credits, 
Preferential Rates, and Deferrals 

Tax expenditures may take any of the. following forms: (1) special 
exclusions, exemptions, and deductions, which reduce taxable income 
and, thus, result in a lesser amount of tax; (2) preferential tax rates, 
which reduce taxes by applying lower rates to part or all of a taxpayer's 
income; (3) special credits, which are subtracted from taxes as ordi- 
narily computed; and (4) deferrals of tax, which result from delayed 
recognition of income or from allowing in the current year deductions 
that are properly attributable to a future year. 

Computing Tax Liabilities 

A brief explanation of how tax liability is computed will help 
illustrate the relationship between the form of a tax expenditure and 
the amount of tax relief it provides. 

CORPORATE INCOME TAX 

Corporations compute taxable income by determining gross income 
(net of any exclusions) and subtracting any deductions (essentially 
costs of doing business). Although the first §25,000 of corporate taxable 
income is taxed at 20 percent and the next $25,000 is taxed at 22 
percent, 1 the corporation income tax is essentially a flat rate tax at 
48 percent of taxable income in excess of $50,000. Any credits are 
deducted from tax liability calculated in this way. The essentially flat 
statutory 7 rate of the corporation income tax means there is very little 
difference in marginal tax rates to cause variation in the amount of 
tax relief provided by a given tax expenditure to different corporate 
taxpayers. However, corporations without current tax liability will 
benefit from tax expenditures only if they can carry back or carry 
forward a net operating loss or credit. 

INDIVIDUAL INCOME TAX 

Individual taxpayers compute gross income which is the total of 
all income items except exclusions. They then subtract certain de- 
ductions (deductions from gross income or "business" deductions) to 
arrive at adjusted gross income. The taxpaj-er then has the option of 
"itemizing" personal deductions or taking the standard deduction. 
The taxpayer then deducts personal exemptions to arrive at taxable 
income. A graduated tax rate structure is applied to this taxable 

1 This rate will expire on June 30, 1976, nnless extended. The rates will then revert to 
22 percent on the first $25,000 and 48 percent on the excess. 

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160 

income to yield tax liability, and any credits are subtracted to arrive at 
the net after-tax liability. 

Exclusions, Deductions, and Exemptions 

The amount of tax relief per dollar of each exclusion, exemption, and 
deduction increases with the taxpayer's marginal tax rate. Thus, the 
exclusion of interest from State and local bonds saves $50 in tax for 
even r $100 of interest for the taxpayer in the 50-percent bracket, 
whereas for the taxpayer in the 25-percent bracket the saving is only 
$25. Similarly, the extra exemption for persons over age 65 and any 
itemized deduction is worth twice as much in tax saving to a tax- 
payer in the 50-percent bracket as to one in the 25-percent bracket. 

In general, the following deductions are itemized, i.e., allowed only 
if the standard deduction is not taken: medical expenses, specified 
State and local taxes, interest on nonbusiness debt such as home 
mortgage pigments, child care expenses, alimony, certain unreim- 
bursed business expenses of employees, charitable contributions, 
expenses of investment income, union clues, costs of tax return prep- 
aration, uniform costs, and political contributions. Whether or not a 
taxpayer minimizes his tax by itemizing deductions depends on 
whether the sum of those deductions exceeds the limits on the stand- 
ard deduction; higher income individuals are more likely to itemize 
because they are more likely to have larger amounts of itemized 
deductions which exceed the standard deduction allowance. Home- 
owners generally itemize because deductibility of mortgage interest 
and property taxes generally leads to larger deductions than the 
standard deduction. 

Preferential Rates 

The amount of tax reduction that results from a preferential tax 
rate (such as the 50 percent maximum tax rate on earned income) 
depends on the difference between the preferential rate and the tax- 
payer's ordinary marginal tax rate. The higher the marginal rate 
that would otherwise apply, the greater is the tax relief from the 
preferential rate. 

Credits 

A tax credit (such as the investment credit) is subtracted directly 
from the tax liability that would accrue otherwise; thus, the amount 
of tax reduction is the amount of the credit and is not contingent upon 
the marginal tax rate. A credit can (with one exception) only be used 
to reduce tax liabilities to the extent a taxpayer has sufficient tax 
liability to absorb the credit. Most tax credits can be carried backward 
and/or forward for fixed periods so that a credit which cannot be used 
in the year in which it first applies, can be used to offset tax liabilities 
in other prescribed years. 

The earned income credit is the only tax credit which is now refund- 
able. That is, a qualifying individual will obtain in cash the amount 
of the refundable credit in excess of his tax liability when he files his 
tax return for the year in which the credit applies. 



161 

Deferrals 

Deferral can result either from postponing the time when income is 
recognized for tax purposes or from accelerating the deduction of 
expenses. In the year in which a taxpayer does either of these, his 
taxable income is lower than it otherwise would be, and because of 
the current reduction in his tax base, his current tax liability is 
reduced. The reduction in his tax base may be included in taxable 
income at some later date. However, the taxpayer's marginal tax rate 
in the later year may differ from the current year rate because either 
the tax structure or the applicable tax rate has changed. Further- 
more, in some cases the current reduction in the taxpayer's tax base 
may never be included in his taxable income. Thus, deferral works to 
reduce current taxes, but there is no assurance that all or even any 
of the deferred tax will be repaid. On the other hand, the tax repay- 
ment may even exceed the amount deferred. 

A deferral of taxes has the effect of an interest-free loan for the tax- 
payer. Apart from any difference between the amount of "principal" 
repaid and the amount borrowed (i.e., the tax deferred), the value of 
the interest-free loan — per dollar of tax deferral — depends on the 
interest rate at which the taxpayer would borrow and on the length 
of the period of deferral. If the deferred taxes are never paid, the 
deferral becomes an exemption. This can occur if, in succeeding years, 
additional temporary reductions in taxable income are allowed. Thus, 
in effect, the interest-free loan is refinanced; the amount of refinancing 
depends on the rate at which the taxpa3^er's income and deductible 
expenses grow and can continue in perpetuity. 2 

TEMPORAKY EXCLUSIONS 

The Domestic International Sales Corporation (DISC) provision 
is an example of deferral through a temporary exclusion of income, 
with recognition of the income for tax purposes occurring subsequently. 
In some cases the deferral may continue indefinitely and the effect 
is a permanent exclusion of taxable income. 

ACCELEEATED DEDUCTIONS 

More commonly, deferrals occur through the acceleration in the 
deduction of expenses. Ordinarily, the cost of acquiring an income- 
producing asset which undergoes economic decline (such as a machine) 
is capitalized and deducted over the asset's useful life. The amount 
of deduction taken in each year depends on the useful life and the 
rate of depreciation applied. The shorter the useful life and the 
higher the rates applied, the more quickly deductions are taken. 
To reflect net income, the share of the asset cost used up in any one 
year should be deducted as an expense against income produced 
by the asset in that year. However, if a larger amount is deducted 

2 The tax expenditures for deferrals are estimates of the difference between tax receipts 
under the current law and tax receipts if the provisions for deferral had never been in 
effect. Thus, the estimated revenue loss is greater than what would be obtained in the first 
year of transition from one tax law to another. The amounts are long run estimates at the 
level of economic activity for the year in question. 



162 

in earlier years, tax liability is lower than it otherwise would be. 
Just the reverse is true in later years when the deduction is lower 
and tax liability is higher than it otherwise would be, and thus a tax 
deferral occurs. 

Rapid write-off methods which are considered tax expenditures 
include: (1) expensing 100 percent of capital costs as incurred, (2) 
using a shorter life (as in the asset depreciation range), (3) using 
a faster rate (as in accelerated depreciation on buildings), and (4) 
using various 5-year amortization provisions. The tax saving from 
various rapid write-off methods is illustrated using the following 
example. 

Assume a $10,000 asset with an even rate of economic depreciation 
over a 10-year life is held by a taxpayer with a marginal tax rate of 50 
percent. The appropriate deduction, in this case l 'straight line", 
would be $1,000 each year and the resulting annual tax reduction 
would be $500 (50 percent of $1,000). 

Expensing capital acquisitions 

If the asset is expensed, the entire amount ($10,000) is deducted in 
the first year, and the tax reduction is $5,000 (50 percent of $10,000). 
This tax reduction is $4,500 greater than the $500 amount resulting 
from the "straight line" method (where 10 percent is written off in 
each year of the 10-year life). In the second and all following years, no 
deduction will be taken. Thus, the net effect of expensing the cost of 
the asset is a $4,500 loan from the government which is paid back with- 
out interest over the next 9 years (as no depreciation is deducted) . 

Shorter than actual useful lives 

The use of any life shorter than the "true" 10-year economic life 
(in this example) provides similar but smaller amounts of tax benefit. 
If an 8-year life is used instead of a 10-year life, the deduction allowed 
in each of the first 8 years is $1,250, and the net tax deferral each year 
is $125 ($1,250-1,000X50 percent) which is ultimately repaid in the 
last 2 years of the asset's actual useful life when no deductions are 
taken. 

Rapid rate depreciation 

There are several rapid rate alternatives to the straight line method. 
The use of a rapid rate simply allows larger deductions in the earlier 
years of the asset's useful life (but does not affect the period over 
which the asset is written off). For example, the declining balance 
method applies a larger than straight line rate against the balance 
(i.e., the asset cost less the allowed depreciation) remaining each 
year. To illustrate with a $10,000 asset, double declining balance 
depreciation in the first year is 2X1/10X$10,000 or $2,000— twice 
the straight line depreciation, for a net tax saving of $500 (50 percent 
of $1,000). In the next year the deduction is 2X1/10X$8,000 or 
$1,600, for a net tax saving of $300. Although depreciation deductions 
will continue over the entire life of the asset, the} r will be larger at the 
beginning and smaller at the end of the period. 

For certain types of machinery and equipment, the pattern of 
economic decline may be mo: 1 closely approximated by a rapid depre- 
ciation method than by straight line. Indeed., the use of an accelerated 



163 

depreciation rate for machinery and equipment is not considered a tax 
expenditure; however, it is considered so for buildings. 3 When, in 
the latter periods under an accelerated depreciation plan, the allowed 
expense is less than the actual depreciation, the difference "repays" 
the loan afforded by the allowance of earlier depreciation in excess 
of actual. 4 

Five-year amortization 

There are several provisions in the tax expenditure budget which 
allow 5-year amortization. Rapid amortization reduces the taxpayer's 
liability by calculating straight line depreciation over an arbitrary 
period — 5 years — which is shorter than the actual useful life of the 
asset. Rapid amortization is a substitute for other depreciation which 
would have been allowed. In the $10,000 example, 5-year amortization 
would yield deductions of $2,000 in each of 5 years. Double declining 
balance depreciation would yield $2,000 the first year, $1,600 the 
second year and with declining amounts thereafter. However, the 
investment credit cannot be taken if rapid amortization is used; 
the taxpayer has the choice of rapid amortization or whatever depre- 
ciation is allowed plus the investment tax credit. If a $10,000 asset 
is eligible for the investment tax credit, an additional $1,000 of tax 
savings would occur in the first year. Thus, the investment tax credit 
plus the regular depreciation is likely to be better than 5 year amortiza- 
tion for the taxpayer in this case. 

For a given asset, rapid amortization provides more tax saving the 
longer is the asset's useful life and the higher is the interest rate and 
the taxpayer's marginal tax rate. In the case of assets eligible for the 
10 percent investment tax credit, it is unlikely the 5-year amortization 
provisions will be a better option. Where the investment tax credit 
does not apply to capital assets (such as housing rehabilitation 
expenditures), the 5-year amortization provision results in more tax 
saving than rapid depreciation if the asset's useful life is long enough. 

3 The explanation for this treatment is that the tax depreciation allowed for machinery 
and equipment is thought to be closer to actual depreciation than that allowed on buildings. 
See 'The Tax Expenditure Budget : A Conceptual Analysis," Annual Report of Secretary of 
the Treasury, FY 1968, p. 33. 

4 The taxpayer has the option to switch to straight line depreciation of the undepreciated 
balance and usually may find it beneficial to do so. However, this option does not change 
the basic result ; it simply increases the amount of interest saving. 



Appendix B 
CAPITAL GAINS 



In the income tax law, profit from the sale of most investment 
assets is referred to as capital gain and receives preferentially lower 
tax rates. For individuals this lower rate is about one-half the usual 
rate although capital gains may also be subject to the minimum tax 
on tax preferences. Corporate long-term capital gains are taxed either 
as ordinary income of the corporation or at an alternative rate of 30 
percent, whichever produces a lower tax. 

Broadly speaking, capital gain or loss is produced by the sale or 
exchange l of capital assets. 2 The sale produces "long-term" gain or 
loss if the property has been owned for more than 6 months. If not, 
it produces "short-term" gain or loss. While the expression "capital 
gains" technically includes both long and short-term gains, it generally 
is used to mean only long-term gains. Only long-term gains receive 
the preferential treatment. 

Stocks and bonds owned by casual investors usually are capital 
assets. Inventory owned b}~ a retailer is not a capital asset. Between 
these extremes, whether property is a capital asset is less clear, and 
in specific cases, the definitional problem ma}' be a very difficult 
matter. In general, however, the distinction is that investments are 
capital assets but items held for sale in a business are not. 

Another kind of property that may produce long-term capital gain 
is property used in a business — generally real estate and depreciable 
property — if it is not held for the purpose of being sold to customers 
and is owned more than 6 months. 3 Gain on this kind of property is 
treated as long-term capital gain only if all of the gains for the year 
exceed all of the losses for the year. If so, the net gain is long-term 
capital gain. 

The gain on a particular sale receives preferential treatment only 
if it survives a number of complex computations. First, losses on long- 
term assets are subtracted from gains on long-term assets. Only the 
net figure survives and is referred to as net long-term gain. Short-term 
losses which have not been used to eliminate short-term gains are then 
offset against this net long-term gain. After this offset, any excess is 
defined by the statute as "net section 1201 gain" but is generally 
called capital gain and is entitled to preferential treatment. 

For individuals, the preference is that one-half of the gain may 
be deducted, and only the other one-half is subject to tax. If this 
calculation produces a tax on the first $50,000 of gains which exceeds 



1 Capital gain treatment is conferred only if there is a "sale or exchange." Othor dis- 
positions, e.g.. an abandonment, do not result in capital gain or loss but rather in ordinary 
gain or loss. This technicality is beyond the scope of this appendix. 

2 This gain or loss will be recognized and taken into income unless one of many non- 
recognition provisions apply. Xon-recognition provisions are beyond the scope of this 
appendix. 

3 The holding period is longer for some assets, most notably livestock. 

(165) 



UNIVERSITY OF FLORIDA 



166 



3 1262 09112 4809 



25 percent of such gains, the lower 25 percent rate is applied to 
the first $50,000 of gains. For corporations, the preference results 
by limiting the tax to no more than 30 percent of the gain. 

The increase in value of capital assets is taxed as a capital gain only 
if the asset is sold. As a consequence, the gross gains on unsold assets 
accumulate in value without being reduced by any accrued tax. 

Without such treatment, accumulation is limited to the after-tax 
gain. Moreover, capital gains accrued at death are transferred to heirs, 
and the gain is exempted from income tax. Gains accrued on assets 
transferred by gift are subject to tax only if the donee sells them before 
his death. 

Note: The following description is provided for the reader who 
wants a more detailed outline of the way capital gains and losses are 
treated : 

First, the gain or loss must be determined on each transaction in- 
volving a capital asset. Then the following procedural rules govern the 
tax treatment of capital gains and losses: 

(1) Long-term gains and losses are aggregated. 

(2) Short-term gains and losses are aggregated. 

(3) (a) If the aggregations in steps 1 and 2 both result in gains, 

long-term gain is treated as stated in step 4(a) and 
short-term gain is treated as stated in step 4 (c) . 
(b) If the" aggregations in steps 1 and 2 both result in losses, 
long-term loss is treated as stated in step 4(b), and 
short-term loss is treated as stated in step 4 (d) . 

(4) If one of the aggregations in steps 1 and 2 produce a loss 

and the other a gain, the gain and loss are then aggregated, 
and the following rules govern: 

(a) If the net is long-term gain, one-half of it is de- 

ducted by an individual in calculating gross in- 
come. An individual may elect for the first. 
$50,000 of such gain to be taxed at a 25 percent 
alternative rate. Corporate long-term capital gain 
is either taxed as other corporate income or at the 
alternative rate of 30 percent, whichever yields 
the lower tax. 

(b) If the net is long-term loss, individuals may deduct 

one-half of it from other income but not in excess 
of $1,000 per year. Corporations may not deduct 
any such loss from other income. There is an un- 
limited carryover to future years for individuals 
but no carryback. Corporations generally ma}^ 
carryback for 3 years and carryforward for 5 
years, to offset capital gain. 

(c) If the net is short-term gain, the entire amount is 

subject to tax. 

(d) If the net is short-term loss, individuals may deduct 

it against ordinary income but not to exceed $1,000 
per year, subject to the previously stated rules on 
carryovers and carrybacks. Corporations may not 
deduct any such loss from other income, subject 
to the rules on carryovers and carrybacks.